Planning for Life

Is an Inherited IRA Protected from Creditors? No!

Posted by Harry S. Margolis on July 15, 2014

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In general under the 2005 Bankruptcy Code, IRAs and other retirement accounts, such as 401(k)s and SEP plans, are protected in the event of bankruptcy by the owner -- one more reason to fund your retirement plan with as much as possible. But what about an inherited IRA? The U.S. Supreme Court recently decided in Clark v. Rameker that they do not enjoy any  bankruptcy protection.

A Short Refresher on IRAs

Inherited IRAs have many similarities to and differences from traditional retirement plans. Most retirement plans are created by the worker setting aside a portion of her income each year into a retirement account. Often the employer contributes as well. The contributions of both the employee and employer are not taxed when the contributions are made, nor are earnings on the funds, such as dividends, interest and capital gains, taxed. However, withdrawals from the retirement plans are taxed when taken. Further, since the purpose of these accounts is to set aside money for retirement, withdrawals made before age 59 1/2 (with exceptions for disability) are also subject to a 10% excise tax or penalty. After age 70 1/2, taxpayers must takeminimum distributions each year starting at 3.65% or face a similar excise tax on the untaken distribution.

And Inherited IRAs

Inherited IRAs come into existence when the owner of a retirement plan passes away and the funds pass to a named beneficiary. Unlike their own retirement plan from which they can delay withdrawals until age 70 1/2, owners of inherited IRAs must begin withdrawals the year following the death of the prior owner. However, since the minimum distributions are set according to age, their required withdrawals can be relatively small. For instance, a 50-year-old owner of an inherited IRA is required to withdraw a minimum of 2.9% of the IRA's value. The tables for inherited IRAs are more accelerated than for retirement plans owned by the original worker. For instance, where at age 70 1/2 a taxpayer must withdraw at least 3.65% or his own retirement plan, at the same age he's required to take out at least 5.9% of his inherited IRA.

There are two instances in which these rules do not apply. First, surviving spouses inheriting retirement plans may roll them over into their own IRAs to which the same rules apply as retirement plans that they fund themselves. Second, if the retirement plan does not have a designated beneficiary, it must be withdrawn within five years after the owner's death. This can occur because there is no named beneficiary, the beneficiary died before the owner and the owner never updated her plan, or a trust was named and it does not meet the specific requirements to qualify as a designated beneficiary to a retirement plan. The result can be higher taxes if the accelerated withdrawals push the recipient into a higher tax bracket or simply the loss of the benefits of deferred taxation.

While every financial planner and estate planning attorney will advise their clients to take the necessary steps to permit their beneficiaries to "stretch" the IRAs and defer taxation as long as possible, our experience is that many people who inherit retirement plans "take the money and run." In other words, while the five-year withdrawal requirement on retirement plans without designated beneficiaries would seem to cause a serious tax penalty for heirs, in fact even when they can stretch their IRAs, we find that many beneficiaries do not take advantage of this opportunity.

Using Family Protection Trusts for the "Stretch" and  Creditor Protection

One way to make sure that beneficiaries take full advantage of the tax deferral opportunity the inherited IRA offers, as well as provide the creditor protection that the Supreme Court in Clark v. Rameker deemed unavailable to owners of inherited IRAs is to leave funds in trust for beneficiaries rather than outright to them. We call these "family protection trusts" because they protect the family from creditors and in the event of divorce, as well as keeping funds in the family if a child passes away at a relatively young age. Beneficiaries may be discouraged from withdrawing IRAs in a family protection trust if they understand that in addition to the tax benefits, they will be giving up the creditor and family protection features offered by the trust.

Here are some articles about family protection trusts:

Pros and Cons of Family Protection Trusts

Protect Your Family from Divorce and Creditors

Family Protection Trusts for Seniors

Margolis & Bloom, LLP, practices estate, long-term care and special needs planning in Boston, Dedham, Framingham and Woburn with a strong commitment to client service.  If you have questions about these or other legal matters, do not hesitate to contact us by e-mail by clicking here or by calling us at 617.267.9700.

Topics: asset protection, Retirement Planning, Probate Estate Administration

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