Inherited IRA Not Protected From Creditors — How To Plan

JUNE 16, 2014 VOLUME 21 NUMBER 22

It’s not very often that the U.S. Supreme Court involves itself in legal issues related to estate planning and elder issues. Last week, though, the Court did just that — by ruling that an inherited IRA is not exempt from the beneficiary/owner’s creditors, at least in a bankruptcy proceeding. What does the decision (in Clark v. Rameker, June 12, 2014) mean for you, and is there any way for you to avoid the result suffered by Heidi Heffron-Clark?

First, let’s figure out how much of a problem the Supreme Court decision creates for you. Let’s suppose that you have diligently contributed to your own IRA, and that you have managed to accumulate a significant sum — just to give it a figure, let’s suppose that your IRA is now worth $300,000. Now suppose that you are involved in an auto accident, and you are sued for injuries caused by the accident. Of course you have auto insurance, and that should take care of most or all of the liability. If your insurance is inadequate, though, can the injured party reach your IRA? The short answer (subject to a handful of exceptions unlikely to apply to you) is an emphatic “No.”

But what if you get divorced — can your soon-to-be-ex-spouse get a share of your IRA? The answer here is generally a qualified “Yes,” but there are specific rules that have to be applied and your actual answer will be very dependent on state law and facts about your marital situation.

One more theoretical question about your theoretical IRA: if you have a series of financial reverses and have to file for bankruptcy, will your IRA be scooped up the bankruptcy court (more accurately, the bankruptcy trustee)? Generally, the answer here is “No.” Your IRA is, in most cases, protected from your creditors — even in bankruptcy.

Does it make a difference if your retirement account is not an IRA but a 401(k) account? No. IRAs, 401(k)s, 403(b)s and most other retirement accounts are similarly protected from creditors and bankruptcy trustees.

Now let’s assume that you didn’t build up that IRA at all — your wife did. She contributed all during her work life, and then she tragically died before she could benefit from the retirement account. She named you as beneficiary, and you “rolled over” her IRA (it could have been a 401(k) or 403(b) — the same rules apply) into a new IRA in your own name. You are now treated as the owner of the roll-over IRA, and it is still exempt from creditors — even though it was inherited.

You can probably see where this is going next. The situation in the Supreme Court case was the next step: Heidi Heffron-Clark’s mother Ruth Heffron was the one who actually built up the IRA. When she died, she named her daughter as beneficiary. Ms. Heffron-Clark was required to begin withdrawing the inherited IRA on a regular schedule, but she chose to leave everything she could in the IRA to continue to earn money tax-free. Then she got into financial trouble, and filed for bankruptcy. The trustee in her bankruptcy proceeding asked the bankruptcy court to order transfer of the IRA to him; he intended to liquidate the IRA and use it to pay Ms. Heffron-Clark’s creditors. She objected that IRAs are exempt from creditors’ claims and bankruptcy, but the court allowed the trustee to gain access.

Ms. Heffron-Clark asked the Federal District Court to overrule the bankruptcy court, and it did. Then the Court of Appeals reversed that finding, ruling that the bankruptcy court (and the bankruptcy trustee) had been right all along. The Supreme Court agreed to review the case, partly because another Court of Appeals from a different Circuit had ruled that an inherited IRA was safe from the bankruptcy trustee. It was important to have a single answer applicable in all U.S. bankruptcy courts.

The Supreme Court agreed that Ms. Heffron-Clark’s inherited IRA had to be paid over to the bankruptcy trustee, and used to pay off some of her debts in bankruptcy. The federal bankruptcy law’s exemption of “retirement funds” did not apply to inherited IRAs, according to the Court, because they were not anyone’s retirement savings — though they were before the original owner’s death.

Now suppose that Ruth Heffron had wanted to preserve her IRA for her daughter, knew that her daughter’s financial health was precarious, and knew that she would likely not live long enough to use the entire retirement account herself. Was there anything she might have done to avoid the result announced in last week’s Supreme Court decision? Yes, as it happens — Ms. Heffron could have simply named a trust for the benefit of her daughter as beneficiary of the IRA (rather than naming her daughter directly), and included appropriate limitations in the trust to protect it from her daughter’s creditors. We have often advocated for creating trusts for inheritances generally, and the Clark v. Rameker decision makes that idea much more compelling, especially for large retirement accounts.

Why would the result be different? Not because there is anything special about retirement accounts, but because it is relatively easy to protect inheritances from the recipient’s creditors by leaving the inheritance in trust — and that same principle applies to retirement accounts. The trust itself is slightly more challenging to create, but worth the effort in many, perhaps most, cases.