Inherited IRAs – Once Protected – Now Possibly Fair Game for Creditors

You should read this article if  –

1. You expect to transfer funds to your descendants through an individual retirement account (IRA); or
2. You have inherited an IRA from a relative.

The U.S. Supreme Court has ruled in Clark v. Rameker that the money in an inherited IRA does not qualify for the protection from creditors as provided in the Federal Bankruptcy Code.[1]

The Court concluded that funds in an IRA which was inherited from someone else are not really retirement funds.  It gave three reasons for this conclusion.  The holder of an inherited IRA:

1. Can never invest additional money into the account.
2. Is required to withdraw money from the account, no matter how far away retirement may be.
3. May withdraw the entire balance of the account at any time – and use it for any purpose – without penalty.

Thus, the Court found, the account is not one set aside for the day when the individual stops working because that individual did not set aside the funds personally – it’s just money, not retirement funds.

If the heir is the owner’s spouse, the Court pointed out, the spouse has two options:

1. The money may be rolled into the spouse’s own IRA, which is protected from creditors, or
2. The spouse may leave the funds in the inherited IRA, losing the protection from creditors.

A non-spousal heir has no options and any inherited IRA funds are not protected from creditors.

In Clark, the Court did not address the issue of an “inherited 401(K)” or similar account. It is likely that the result will be the same, as the 401(K) account becomes an inherited IRA upon death. On the other hand, the result could differ depending upon the language of the 401(K) plan under which the account had been administered. We’ll have to wait for further judicial rulings on those situations.

GOOD NEWS IF YOU ARE A RESIDENT OF MISSOURI or any other state which has elected not to follow the Federal exemptions: All of the states have laws which protect certain assets of its residents from the collection efforts of creditors. Unlike most federal laws, the Bankruptcy Code provides that the states may ‘opt out’ of the exemptions provided in the Bankruptcy Code and utilize their own exemptions instead. Missouri has opted out. Its IRA exemption statute reads almost word for word like the Bankruptcy Code provision provision except that the protection extends to all IRAs, regardless of whether it “arises by inheritance, designation, appointment or otherwise.” Thus, unless the state legislature amends the statute, inherited IRAs held by Missouri residents are still protected.

So, what should you do?

If you are the individual who built up the retirement funds and have named beneficiaries other than your spouse to receive them upon your death, you have a few things to worry about, unless you’re extremely confident that the beneficiaries won’t move out of Missouri and that the existing statute won’t be amended.

If the beneficiary of your generosity works in a profession at greater risk for being sued, if they are spendthrifts and need protection from themselves, or if you simply are very conservative and are concerned about life’s everyday risks, you may want to consider naming a trust or similar protected vehicle as the beneficiary rather than the individual.

If you are or know you will be the recipient of an inherited IRA, you also need to be concerned about the Supreme Court’s ruling unless, again, you’re not planning to move and have confidence in the Missouri legislature.  If you are one of the above-mentioned types of people, you may wish to take some action now to protect your assets, such as increasing your insurance coverage, opening a new IRA with the funds, putting the money into a joint account with your spouse[2], and/or moving funds into a protected vehicle, such as a trust, or some other asset protection strategy.

Because some of these actions require waiting periods or have other traps, you should check with a bankruptcy or estate planning attorney, and possibly an accountant, regarding your best options before you take any action.

Updated 7/15/14