Inherited IRAs Are Not Protected from Creditors

In a major 2014 decision, the Supreme Court ruled that inherited IRAs are not considered protected retirement funds—and are thus subject to creditors’ claims if the beneficiary files for bankruptcy.

In Clark v. Rameker, Heidi Heffron-Clark argued that a $300,000 IRA she inherited from her mother in 2001 qualified as a protected retirement account. As such, she contended that the account was exempt from the claims of creditors after Heffron-Clark and her husband filed for bankruptcy in 2010.

However, under the Internal Revenue Code provisions regarding inherited IRAs, Heffron-Clark was required to withdraw a minimum amount of money from the account each year, even though she is not yet retirement age. Given this, the court decided the account was not a protected retirement fund because the beneficiary was not using it as one.

Why does this decision matter?

The Clark v. Rameker decision means that in the case of bankrupt estates, inherited IRAs will be considered assets—fully available to satisfy creditors’ claims. If you pass a retirement fund down to a child or grandchild, that inherited money will not be protected if your beneficiary must file for bankruptcy.

What should I do?

Careful estate planning can ensure that inherited IRAs remain safe from your beneficiary’s creditors. In most cases, establishing a standalone retirement trust will protect your assets without restricting your beneficiary’s access to them.

How does it work?

Upon the retirement plan participant’s passing, the participant’s funds will flow into the third-party trust instead of passing directly to the beneficiary. Because the beneficiary does not establish the trust, does not fund the trust with the beneficiary’s own money, and cannot modify the trust, the trust will—in most jurisdictions, and if properly drafted—enjoy substantial protection from the claims of the beneficiary’s creditors. An independent trustee who is not the beneficiary can also be appointed to oversee the trust’s distributions to ensure further protection from creditors’ claims.

Will the SECURE Act affect my plan?

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law on December 20, 2019, and effective for participants who die after 2019, brought about significant changes to federal tax law and retirement plans in particular. Under prior law, the beneficiary of an inherited IRA was generally required to withdraw a minimum amount of money from the account each year, and the amount was calculated so that the account would stretch over the beneficiary’s life expectancy in most cases (including Clark). This stretch enabled a younger beneficiary to grow the inherited IRA substantially (and income tax-free), sometimes over many decades. Under the SECURE Act, stretch treatment abruptly ends in the tenth year after the participant’s death in most cases. There are exceptions for the following types of beneficiaries (called Eligible Designated Beneficiaries or EDBs), who may still qualify for stretch treatment:

• surviving spouse of an account owner
• person who is not more than ten years younger than the account owner
• minor child of the account owner
• disabled person
• chronically ill person

Regardless of whether a standalone retirement trust is established for a beneficiary that is an EDB, the trust’s degree of creditor protection will depend on its status as a conduit or accumulation trust. Generally, an accumulation trust may offer greater creditor protection than a conduit trust: any distribution from the IRA that a conduit trust receives must be immediately distributed out to the beneficiary, whereas IRA distributions that an accumulation trust receives may build up inside the trust.

After the SECURE Act, conduit trusts and accumulation trusts still function the same way. However, you should talk with a competent estate planning attorney to make sure you understand the income tax consequences of the two types of trusts. Although accumulation trusts offer greater creditor protection, retirement assets distributed to and held by an accumulation trust will usually be taxed at a much higher income tax rate than retirement assets passed out of the trust to a beneficiary.

What do I need to do?

Make an appointment with an estate planner in your area to discuss your options. Standalone retirement trusts must be drafted carefully to ensure that the trust qualifies as a Designated Beneficiary and is designed as either a conduit or accumulation trust to meet your objectives. This guarantees that the trustee of the trust will be able to take out the minimum required distributions according to the beneficiary’s life expectancy, not the plan participant’s, if the beneficiary is an EDB. Alternatively, the trustee of the trust will be able to withdraw the account under the ten-year rule for beneficiaries that are not EDBs. If the trust is not set up properly, the entire inherited IRA will need to be withdrawn within five years of the plan participant’s death. Work with a reputable planner to make sure your trust is structured correctly and that your beneficiary—and not the beneficiary’s creditors—will receive the funds you pass down. To find an estate planning attorney near you, search our directory here.