Inherited IRAs in bankruptcy cases

The Supreme Court ruled unanimously last month that inherited individual retirement accounts are not protected under federal bankruptcy laws. This ruling does not affect your clients’ own IRAs. Those are retirement funds that are protected in bankruptcy. The problem is when your client dies and their children inherit the IRA. Your clients should know that the IRAs they built could be lost by their children if they declare bankruptcy.

In the Supreme Court case, Ruth Heffron named her daughter, Heidi Heffron-Clark, as her IRA beneficiary. In 2001, Ruth died. In 2010, Heidi and her husband filed for bankruptcy when the inherited IRA was worth about $300,000.

As part of the bankruptcy proceedings, Heidi claimed the inherited IRA as an exempt asset consisting of “retirement funds” as prescribed by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

But Ms. Heffron-Clark’s creditors questioned whether the term “retirement funds” included inherited IRAs, since the IRA was not her retirement account, it was her mother’s, and thus was not protected under the federal bankruptcy rules. The primary issue before the Supreme Court was whether or not an inherited IRA is a retirement account.

THREE CHARACTERISTICS

The high court said it is not, citing these three characteristics of inherited IRAs that were not characteristics of a “retirement” account:

• Beneficiaries cannot add money to inherited IRAs in the way IRA owners can to their own accounts.

• Beneficiaries of inherited IRAs must generally begin to take required minimum distributions in the year after they inherit the account, regardless of how far away they are from retirement.

• Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a penalty.

The court decided that inherited IRAs do not contain “retirement funds” and, as a result, are not protected under the federal bankruptcy law. In other words, when the IRA owner dies and the funds transfer to a beneficiary, the funds are no longer retirement funds.

Does this ruling affect spouses who inherit an IRA? The Supreme Court’s decision does not explicitly state one way or another.

One possibility is that the Heffron-Clark decision will not apply to a spouse who inherits an IRA. There are a number of special rules for spousal beneficiaries under the Tax Code that create a clear distinction between spouse and non-spouse beneficiaries. At some point. a creditor or bankruptcy trustee will force the issue to be decided by the courts.

The question for many clients now is, “How can I keep my hard-earned money away from my beneficiaries’ creditors after I’m gone?” For some, state law may provide protection. The Supreme Court’s decision did not say that inherited IRAs can’t be protected in bankruptcy, but rather, that they are not protected from bankruptcy under the federal bankruptcy statutes. That does not, however, preclude states from offering bankruptcy protection — or, for that matter, creditor protection in non-bankruptcy situations — to inherited IRAs under state law. In fact, to date seven states have adopted laws expressly exempting inherited IRAs under state bankruptcy statutes. Those states are Alaska, Arizona, Florida, Missouri, North Carolina, Ohio and Texas.

For residents of states with no inherited IRA protection, there are still a number of options to protect your clients’ retirement funds after they’re gone. Perhaps the most obvious approach is to name a trust as the IRA beneficiary. If drafted properly, certain requirements are met and the trust contains appropriate language, it can help shield the trust assets from the trust beneficiaries’ creditors while still allowing the trust to stretch distributions from the inherited IRA.

However, trusts are complex and have high tax rates, but a Roth IRA conversion during the owner’s lifetime could help alleviate the trust tax issues.

Another potential option to consider is to use some of the IRA money to buy life insurance, and leave the life insurance to a trust. While this approach still incorporates a trust, life insurance is, for a host of reasons, a much more “trust-friendly” asset than an IRA or Roth IRA. Plus, life insurance proceeds are generally tax free, reducing the impact of high trust taxes.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.