Have an Inherited IRA? Supreme Court Ruling Affects Creditor Protection

In our work with Entrepreneurs and Physicians, issues of asset protection always come up.  We understand the rules associated and  work with clients alongside their legal advisors to protect the assets they’ve worked so hard to accumulate.

In the event of a catastrophic financial loss or lawsuit, a number of assets are protected by state law, including personal residences and retirement accounts (up to certain limits).  It has long been considered that Inherited IRAs would benefit from this additional protection as well.  However, a recent unanimous Supreme Court decision has changed that entirely.

The Supreme Court ruling in Clark v. Rameker has clarified that in the eyes of the court, Inherited IRAs aren’t retirement accounts at all, because of a few key points:

• Accessibility – There are no early withdrawal penalties on Inherited IRAs, and while most beneficiaries defer distributions, the entire amount is accessible at any time.
• Contributions – The beneficiaries inheriting the IRA cannot by law make contributions to the account, thus making it distinct from other retirement accounts like 401ks where contributions are being deferred out of an individual’s own income.
• Required Distributions – Since participants are required to take funds out every year, the court ruled that “the possibility that an account holder can leave an inherited IRA intact until retirement and take only the required minimum distributions does not mean that an inherited IRA bears the legal characteristics of retirement funds. Therefore, the “retirement funds” bankruptcy exemption should not apply.”

There are still a number of open questions that this case does not settle.  Spouses who inherit an IRA from a deceased spouse can often roll those into their own IRA, and particularly in community property states like Louisiana, it could be argued that these are assets that both spouses intended to use for their retirement and thus should be protected.  This issue hasn’t been challenged and settled, so it’s likely that future bankruptcy proceedings will take this into account and generate a precedent in coming years.

So what are some planning strategies that can be used to try to enhance protection?

• Maintain assets in ERISA retirement plans (such as 401k/Profit-sharing plans).  Our default strategy has long been to recommend rollovers of these assets to IRAs for flexibility and control, but for those with greater asset protection concerns for their heirs, maintaining these accounts may afford greater protection under the ERISA statutes.  It may well come to pass that this will be challenged and harmonized with the new Inherited IRA ruling, but it is a tool in the toolbox that should be considered
• Trusts as beneficiaries – A trust can be named as the beneficiary of an IRA, which could provide additional bankruptcy protection, but that will come with the cost of (likely) paying a higher income tax rate on those trust assets as taxation rules differ for trusts and individuals.
• Umbrella Liability Insurance – While this won’t protect clients from every situation, a major concern is that of an accident in one’s vehicle or at their home.  Umbrella Liability Coverage is a powerful, relatively inexpensive way to provide a substantial amount of protection for one’s assets.

All of the above is to say that everybody’s situation is unique and deserves an in-depth look to determine what balance of protection and cost is appropriate for each individual or family.

For more details, read my friend Michael Kitces’ in-depth post on the topic: An Inherited IRA is not a Retirement Account for Bankruptcy Protection under Clark v Rameker Supreme Court Case.