Landmark Supreme Court Decision Exposes Inherited IRAs To Creditors In Bankruptcy

The U.S. Supreme Court held in Clark v. Rameker that inherited IRAs are not “retirement funds” within the meaning of 11 U.S.C. §522(b)(3)(c), a federal bankruptcy law. This means inherited IRAs are available to satisfy creditors’ claims.

How the SCOTUS Reached Its Decision

The Court relied upon three factors to differentiate an inherited IRA from a participant-owned IRA. The three factors include: (1) the beneficiary of an inherited IRA cannot make additional contributions to the account, while an IRA owner can, (2) the beneficiary of an inherited IRA must take required minimum distributions from the account regardless of how far away the beneficiary is from actually retiring, while an IRA owner can defer distributions at least until age 70 ½, and (3) the inherited IRA beneficiary can withdraw all funds in the IRA at any time and for any purpose without a penalty, while an IRA owner must generally wait until age 59 1/2 to take penalty-free distributions.

The ramifications of the Clark decision in estate planning cannot be understated. Why? Because the rationale applied in this case could extend to all inherited defined contribution retirement plan accounts, including inherited 401(k) and 403(b) accounts.

Ways to Protect Inherited IRAs from Creditors

There are several ways to try and protect these assets from your beneficiaries’ creditors. One possible solution may be to create a Standalone Retirement Trust for the benefit of all of the intended IRA beneficiaries. This type of trust offers some distinct benefits: (1) protecting the inherited IRA from each beneficiary’s creditors, (2) protecting the beneficiary from gambling away the inherited IRA, and (3) permitting minor beneficiaries, such as grandchildren, to be immediate beneficiaries of the inherited IRA without the need for a court-supervised guardianship. This is not an exhaustive list of benefits, just a sample. Additionally, you can get similar benefits to a Standalone Retirement Trust by including certain language in a revocable trust and naming it as the beneficiary of the IRA.

Both of these strategies have pros and cons, and it is extremely important to talk with an experienced estate planner working closely with your financial advisor to discuss your specific situation and concerns.

State Exemptions Could Still Protect Inherited IRAs

Multiple states, including Alaska, Arizona, Florida, Idaho, Missouri, North Carolina, Ohio and Texas either passed laws or had favorable court decisions, post-Clark, that protect inherited IRAs under state bankruptcy exemptions for federal bankruptcy purposes. This means if you live in one of these states, you may be able to protect your inherited retirement funds by claiming the state exemption instead of the federal exemption.

But be careful – federal bankruptcy laws require a debtor to reside in a state for at least 730 days prior to filing a petition for bankruptcy. This means if you’ve only lived in one of the aforementioned states for a period less than two years, you may not be able to take advantage of the state’s bankruptcy exemption.

Conclusion

The Clark decision is a prime example of why you need to sit down and talk with an experienced estate planning attorney. These decision are not something that be done with a cookie-cutter estate plan you download from the internet. You need someone knowledgeable about all of the different beneficiary choices for retirement assets, and how those will fit with your personal estate planning goals.