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U.S. Supreme Court rules that an inherited individual retirement account (IRA) is not protected from creditors in bankruptcy

June 16, 2014

Retirement accounts are one of the largest assets decedents leave to heirs upon death and post-mortem tax planning plays a crucial role in continuing the IRA’s income tax deferral. A non-spouse beneficiary who receives an IRA from a decedent can elect income tax deferral benefits through an inherited IRA. An inherited IRA can lead to significant income tax deferral over the beneficiary’s lifetime. This deferral avoids the immediate income tax consequences of “cashing out” the IRA after the decedent’s death.

A recent U.S. Supreme Court case is troubling for anyone relying on the income tax benefits of inherited IRAs. Clark v. Rameker, No. 13-299, held that an inherited IRA is not excluded from a bankruptcy estate under the “retirement funds” exception. The U.S. Supreme Court reasoned that the purpose of the “retirement funds” exception is so debtors can meet their basic needs during retirement. There are limitations on a debtor’s ability to withdraw IRA funds and require waiting until age 59 ½ to avoid penalties. An inherited IRA is different. An inherited IRA can be “cashed out,” without penalty, and allow the beneficiary to use the entire balance immediately for non-retirement purposes. This would allow the beneficiary to protect the inherited IRA during bankruptcy and immediately spend the IRA on non-retirement needs after the bankruptcy. The U.S. Supreme Court reasoned the inherited IRA rules give beneficiaries a “free pass.” This is different from “retirement benefits” that are protected for a retiree’s basic needs. 

However, a trust can alleviate the concern that an IRA passed to a non-spouse beneficiary will be available to creditors. A properly drafted trust can provide the same income tax deferral benefits of an inherited IRA while providing creditor protection no longer available to inherited IRAs post-Clark. While a trust is more complicated to set-up and administer, the significant creditor protection benefits should be carefully considered to ensure hard-earned IRAs are not exposed to creditors of a beneficiary after death. 

Tax and estate planning for retirement benefits is complex and unique to each client. We encourage you to look at your current plan. If you have any questions, or think that your plan needs to be changed, we urge you to contact us soon so we can help ensure your plan is current and effective. 

 

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