Inherited IRAs Are Not Asset Protected. Important New Decision.

Posted By Sarah Kaufman || 26-Jun-2013


For Clients, Advisors and Community: Individual Retirement Accounts (IRAs) are becoming an increasing portion of wealth transferred from generation to generation. Do you have or do you anticipate owning an Inherited IRA from a parent or grandparent? If you do, this article applies to you.

What is It? An “inherited IRA” is an IRA inherited from a third party (usually a parent). It typically does not include a spouse. More often than not, a surviving spouse will roll his or her deceased spouse’s IRA into his or her own IRA which would be protected. In Illinois, a specific statute makes it clear that retirement savings accounts (IRAs, annuities and to some degree life insurance) is protected from the claims of creditors. It is not clear with respect to inherited IRAs. For a long time, we were certain that the courts would inevitability decide whether this protection extends to inherited IRAs.

New Court Ruling. On April 23rd, 2013, the (Federal) Seventh Circuit Court of Appeals ruled that an inherited IRA is not exempt as against a bankruptcy creditor. (In the Matter of Brandon C. Clark and Heidi Heffron Clark, Nos. 12-1241 & 1255. The Seventh Circuit governs Northern Illinois, Southern and Western Wisconsin and Western Indiana. This becomes important in our little drama. Heidi inherited an IRA valued at approximately $300,000. Subsequently, Heidi and her husband filed bankruptcy. The court, in dicta (part of the opinion not directly on the issue presented) stated that if the inherited IRA was in a trust, then it might not be subject to the claims of Heidi’s creditors in her bankruptcy.

Could it Be Overturned? There are thirteen Circuit Courts of Appeal. Two have ruled differently. They have taken the position that inherited iRAs are, in fact, retirement funds and therefore should receive the creditor and asset protection afforded conventional IRAs. When the circuits differ, the Supreme often (but not always) resolves the conflict. In the interim, at least within the area of the Seventh Circuit, there is no protection. ( Four of the nine justices need to vote for a case to be heard by the Supreme Court).

The Problem. To all of this legal gobbledy-gook, you might say, “We’ll I’m never going to go bankrupt”. It is unfortunate that, even in this day and age, the rate of bankruptcy doubles with a cancer diagnosis. There is an increased risk of bankruptcy in the event of an accident involving serious brain or spine injury. A simple web search reveals dozens of law firms trumpeting multi-million dollar verdicts. It can happen to anyone.

A Solution. Creditors and predators cannot usually penetrate an irrevocable trust set up by a third party. In the recent past, we have used a special Retirement Plan Trust to make sure that inherited IRAs are not exposed to creditors and predators. Often, we will structure the plan so that the spouse is the direct beneficiary. She will roll her benefit directly to her own IRA. In Illinois, the IRA will be fully asset protected. Upon her death, the IRA will be directed to this special Retirement Plan Trust that has already been created by her (now deceased) husband. It’s a third party irrevocable trust. So, the inherited IRA will be protected under trust law irrespective of the Illinois statutory protection or the Federal Circuit Court of Appeals decision on whether or not it is intended for retirement benefits.

Action Plan. If you have an IRA with a significant balance (or a 401(k) plan account with a significant balance and are contemplating retirement soon), you should of course plan to minimize taxes in the long term. But, you should also ensure that the retirement savings for which you worked all your life is secure not only for you and your spouse, but also for your beneficiaries.

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