In a landmark, unanimous decision handed down on June 12, 2014, the United States Supreme Court held that inherited IRAs are not “retirement funds” and therefore not protected from creditors (Clark, et ux v. Rameker, 573 U.S. (204)).

This ruling is important to you and your family because it means you need to take action to insure that your retirement funds are protected when they pass to the next generation – and, perhaps, even to your spouse.

Here’s what happened in the Clark case:

Ruth Heffron created an IRA, naming her daughter, Heidi Heffron-Clark, as beneficiary. After Ruth died, Heidi transferred the IRA assets (approximately $300,000) into an “Inherited IRA.”

Some nine years later, Heidi and her husband, Brandon, filed bankruptcy and sought to protect the Inherited IRA from their creditors. The couple argued the inherited IRA assets were protected retirement funds. Both the bankruptcy trustee and the judgment creditors objected.

The case went all the way to the Supreme Court, which ruled that funds held within an inherited IRA are not “retirement funds.” And, as a result, those funds have no protection as retirement funds and can be seized to pay off debt.

The Court reached its conclusion using three elements, which differentiate an inherited IRA from a participant-owned IRA:

  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.
  3. The beneficiary of an inherited IRA can withdraw all of the funds 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.

This simple analysis has sent shock waves through the estate planning and financial advisory worlds. The logic is easily extended to all inherited defined contribution retirement plan accounts, so inherited 401(k) and 403(b) accounts are also affected. Having lived with this decision for a year, its impact is becoming clear.

What Can Be Done to Protect Inherited IRAs?
In light of the Clark decision, clients must thoughtfully reconsider any outright beneficiary designations. By far the best option for protecting an inherited IRA is to create a Standalone Retirement TrustThis is a specialized trust separate from your regular living trust to specifically handle retirement plan assets. If properly drafted, this trust offers the following advantages:

  • Protects the inherited IRA from beneficiaries’ creditors as well as predators and lawsuits
  • Insures that the inherited IRA remains in the family bloodline and out of the hands of a beneficiary’s spouse, or soon-to-be ex-spouse
  • Allows for oversight of the IRA assets by a third party or professional trustee
  • Prevents the beneficiary from spending away the inherited IRA too quickly and not saving for the future
  • Enables better planning options so that you can customize provisions for certain children or descendants that need enhanced protection, spendthrift restrictions or for a special needs beneficiary
  • Permits minor beneficiaries such as grandchildren to be immediate beneficiaries of the inherited IRA without the need for a court-supervised guardianship
  • Allows for more flexible planning under certain IRS rules regarding retirement plan distributions and can simplify the process of obtaining acceptance of a beneficiary designation which involves trusts
  • Facilitates generation-skipping transfer tax planning for retirement assets to insure that estate taxes are minimized or even eliminated at each generation

Planning TipA standard revocable living trust agreement generally will not be well-suited as the beneficiary of an IRA because it will rarely qualify under IRS rules as a “see-through trust.” If the trust doesn’t qualify as a see-through trust, the beneficiary will not be able to “stretch” distributions from that trust, thereby causing income taxation of IRA distributions on an accelerated basis.

Could the Clark Decision Put IRAs Inherited by Spouses at Risk?
In Clark v. Rameker, the IRA was inherited by the daughter of the owner. Would the decision have been different if the IRA was, instead, inherited by a spouse?

When a spouse inherits an IRA, he or she has three options:

  1. Take a distribution of the entire inherited IRA and pay the associated income tax.
  2. Keep the IRA as an inherited IRA.
  3. Roll over the IRA into his or her own IRA, after which it will be treated as the surviving spouse’s own IRA.

Under the first option, the distributed IRA will no longer be an IRA of any kind, and will lose any creditor protection it had as an IRA. The proceeds will become the asset of the surviving spouse.

Under option 2, using the rationale of the U.S. Supreme Court in the Clark case, the inherited IRA will not be protected from the spouse’s creditors since the spouse is prohibited from making additional contributions to the account, may be required to take distributions prior to reaching age 70½, and can withdraw all of it at any time without a penalty.

In the third option, a rollover does not happen on its own and takes time to complete, and even after a rollover is accomplished, the funds that were rolled over were certainly not contributed by the spouse for his or her own retirement before the rollover was initiated.

Speculation among commentators is rampant regarding whether an IRA inherited by a spouse is affected by this decision. Unfortunately, we may not know the outcomes of these issues for some time to come.

Planning TipProvisions can be made in a Standalone Retirement Trust for the benefit of a spouse. This may be important for many reasons aside from creditor protection, including a second marriage with a blended family or, when coupled with disclaimer planning for a spouse who eventually needs nursing home care and seeks to qualify for Medicaid. A layered IRA beneficiary designation which includes a Standalone Retirement Trust and disclaimer planning can offer a great deal of flexibility for clients who want to insure that their hard-saved retirement funds stay in their family’s hands and out of the hands of creditors and predators.

Could State Law Still Protect Inherited IRAs?
A handful of states – including Alaska, Arizona, Florida, Idaho, Missouri, North Carolina, Ohio and Texas – have either passed laws or had favorable court decisions that specifically protect inherited IRAs under state bankruptcy statutes. If the IRA beneficiary is lucky enough to live in one of these states, then that beneficiary may very well be able to protect their inherited retirement funds by claiming the state law exemption instead of the federal law exemption.

Caution: Caution should be used in relying on state law to protect a beneficiary’s inherited IRA. In general, people are more mobile than ever and your beneficiary may need to move from state to state to find work, pursue educational goals, or be closer to family members. In addition, federal bankruptcy laws now require a debtor to reside in a state for at least 730 days to use state bankruptcy exemptions. Therefore, long-term planning should not rely on a specific state law but instead should take a broad approach.

The Bottom Line
This is certainly not one-size-fits-all planning and can only be done on an individual, case by case basis. If you have retirement funds, we can show you how to protect your assets from your beneficiaries’ bankruptcy creditors, divorcing spouses, frivolous lawsuits, medical crises, and bad decisions. This is a decision that requires your immediate attention. A Standalone Retirement Trust is an additional tool separate from your regular living trust. For many of you, your retirement assets comprise a large part of your estate; for some, it is the bulk of the estate that you hope to pass on to your beneficiaries. Protection of that asset is of the utmost importance to you, and to your beneficiaries.