Bankruptcy Protection for Inherited IRA

By Robert J. Lowe

The already complicated subject of how to handle Individual Retirement Accounts following the death of an IRA holder just got a little more complicated with the recent Supreme Court decision in Clark v. Rameker. The issue in this case was whether an “inherited IRA” enjoyed the same protections under federal bankruptcy law as other IRAs. The Supreme Court held that it did not, making it easier for creditors to reach the assets held in these types of IRAs.

An “inherited IRA” exists when an IRA holder dies and the IRA holder has designated someone other than the IRA holder’s spouse as beneficiary. This could occur, for example, if the IRA holder names a child, parent, domestic partner or trust as beneficiary. An inherited IRA generally does not exist if the surviving spouse is the beneficiary because, under a special rule in the Internal Revenue Code, the surviving spouse can designate the IRA in that case as the spouse’s own IRA as though the spouse had contributed to it.

When an inherited IRA is created on the death of the IRA holder, required minimum distributions must generally be taken either over the lifetime of the beneficiary starting in the year following the year of the IRA holder’s death or the IRA must be completely distributed within five years following the year of the IRA holder’s death. In most cases, distribution over the lifetime of the beneficiary results in the greatest tax free build-up in the IRA so these inherited IRAs can exist for a significant period of time.

In the Supreme Court case, an IRA holder designated her daughter as beneficiary of her IRA. When the IRA holder died with $450,000 in her IRA, the IRA became an inherited IRA for the benefit of the daughter. Several years later the daughter and her husband filed for bankruptcy under Chapter 7 and claimed that the inherited IRA should be exempt from the reach of creditors. The daughter’s position was based on a provision of the federal bankruptcy law that provides that “retirement funds” are excluded from the bankruptcy estate “to the extent those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457 or 501(a) of the Internal Revenue Code.”

Although IRAs, including inherited IRAs, are exempt from taxation under Section 408 of the Internal Revenue Code, the Supreme Court held they were not “retirement funds” because (1) new contributions can never be made to an inherited IRA, (2) distributions must be made over the beneficiary’s lifetime or within five years after the year of the IRA holder’s death and are not delayed until the beneficiary’s retirement and (3) withdrawals from an inherited IRA are not subject to the penalty for distributions prior to age 59-1/2 that applies to other IRAs, making it easy for the beneficiary to withdraw funds at any time.

Accordingly, the Supreme Court held that the inherited IRA was part of the bankruptcy estate and its assets could be reached by the daughter’s creditors.

This decision presents another factor that IRA holders should take into account in making the already complicated decision of who should be the IRA beneficiary. This decision would appear to present another reason for naming the surviving spouse, if possible, as beneficiary since the surviving spouse would appear not to be subject to this decision. However, that may only postpone the issue since if IRA assets remain on the death of the surviving spouse, the resulting IRA will inevitably be an inherited IRA for other beneficiaries subject to this decision. For IRA holders who have concerns about the risk that potential beneficiaries may seek bankruptcy law protection, this decision may present a reason not to designate those individuals as IRA beneficiaries.

As with most issues in this area, there is no “one size fits all” solution and the IRA holder should discuss these issues with family members and advisers.

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