Recent Supreme Court case offers lessons for managing inherited IRAs

Inherited IRAs being impacted by bankruptcy is a remote event, but advisers and clients should still be prepared

Assets held in IRA accounts totaled more than $7 trillion at the end of the second quarter of 2014, according to the latest available data. Based on our rapidly aging population and other factors, it’s reasonable to assume significant and increasing numbers of those dollars will be passed along to IRA holders’ beneficiaries.
As most of us in the financial services industry are aware, the recent Clark v. Rameker Supreme Court decision held that assets in inherited IRAs cannot be considered “retirement funds” in the event of a Chapter 7 personal bankruptcy within the meaning of the statute protecting such funds.
This ruling represents an opportunity.

“BETTER SAFE THAN SORRY”

Odds are that Clark v. Rameker will impact very few, if any, of your clients or their beneficiaries since it applies only to those individuals who have inherited IRA assets and are declaring bankruptcy.
Consequently, given these “favorable odds,” certain IRA account holders will very likely suggest that there’s no reason to be concerned about what’s going to happen to their IRA assets in the event one or more of their beneficiaries declares bankruptcy, because “that will never take place.”
That argument can be countered by invoking the old saw, “better to be safe than sorry.” And the truth is, those of us who advise investors have a responsibility to assist them and their beneficiaries in being reasonably prepared for unanticipated bumps in the financial road.

SPOUSAL IRAs

Then there’s the matter of spousal beneficiaries.
Clark v. Rameker involved a next-generation beneficiary and, in handing down its decision, the court was unclear as to how the assets in an inherited spousal IRA are to be treated in the event the surviving spouse declares bankruptcy.
Although this area remains clouded with uncertainty, there are strategies to be considered and perhaps deployed. If the surviving spouse has no immediate need for the inherited IRA assets, a potential solution may be for the surviving spouse to roll over the assets into his or her own IRA.
If the surviving spouse has not reached age 70 1/2 but the deceased spouse had, rolling over the assets enables the spouse to delay taking distributions until age 70 1/2 rather than continuing to take the deceased spouse’s required minimum distributions.
If the surviving spouse is under age 59 1/2, he or she will be subject to the standard 10% early withdrawal penalty if the assets are rolled into their own IRA before the distribution. However, if the assets are in an inherited IRA, the surviving spouse can make withdrawals penalty free, even when under age 59 1/2.
There are two good reasons for discussing the possible ramifications of Clark v. Rameker with your clients: We’ll call them “The Unexpected” and “The Unknown.”
For many investors, especially high-net-worth investors, the most logical solution for addressing these and other related considerations may lie within a retirement trust.

TRUSTS

It’s long been established that certain types of trusts can be named as an IRA beneficiary. However, they must be properly structured in order to realize the tax-deferred benefits of the IRA over the life of the beneficiary or beneficiaries.
Once the issue of whether state or federal law applies is resolved, an experienced trust and estate attorney will be able to draft a Standalone Retirement Trust. These instruments enable underlying beneficiaries of the trust to protect the IRA assets from all creditors and estate taxes, and to provide controlled management of the assets with spendthrift protection.
Not surprisingly, there are potential downsides to these types of trusts, including the application of trust income rather than much lower personal income tax brackets, ongoing administration and other fees, and potential generation-skipping taxation in the event all or a portion of the assets are transferred to a third generation.

THE OPPORTUNITY

We’re not breaking any new ground here, nor are we attempting to. It’s simply a matter of pointing out that, when addressing the issues resulting from Clark v. Rameker, there’s a real opportunity to also discuss with donors (and possibly their beneficiaries) a broader range of retirement issues, as well as a myriad of other long-term financial planning considerations.
Our advice: The total financial welfare of clients should be our highest priority. Even though an inherited IRA being impacted by bankruptcy is a remote event, we should remain proactive with clients and guard against the unexpected with strong communication and education on this topic.
Stuart Riemer is a director with HighTower’s Treasury Partners and a member of the firm’s wealth management team.