So, you’ve transferred your 401(k) retirement nest egg into an individual retirement account (IRA). This gives you more control over management and distribution of IRA assets. But, you may have concerns about creditors and their ability to attack your retirement assets, which are now conveniently consolidated from several employer plans into one convenient IRA. Will those IRA assets be protected from creditors regardless of what happens to you?
Employer sponsored retirement plans, such as 401(k) plans, are protected from creditors by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “Act”) as well as a specific ERISA statutory provision. The Act also protects other “retirement funds” like IRAs, in an aggregate amount of up to $1,000,000 (indexed for cost of living increases and now set at $1,245,475). The protection from creditors is implemented through an exemption from the assets available to creditors in bankruptcy, and this protection is available on a nation-wide basis (individual states can elect alternative exemptions).
Do “inherited” IRAs set up on the death of an IRA holder for a named beneficiary fall within the category of “retirement funds” protected by the Act? The U.S. Supreme Court recently considered this issue in Clark v. Rameker, a case involving the assets of a mother’s IRA inherited by the named beneficiary (her daughter) upon the mother’s death. The daughter subsequently filed for bankruptcy and the IRA assets were claimed to be part of the daughter’s bankruptcy estate to be shared by her creditors. The Supreme Court concluded that such inherited IRAs are not retirement funds in the hands of the beneficiary (in this case, a non-spouse beneficiary) who may be a younger family member many years from retirement, and so such inherited IRAs are not protected from creditors by the Act. Left undecided by the Supreme Court is the status of inherited IRAs benefitting surviving spouses (favorable language in the lower court opinion in Clark suggests that inherited IRAs in the hands of a surviving spouse continue to be retirement funds).
The Supreme Court’s decision does not deal with bankruptcy protection of retirement funds like IRAs in those states which have bankruptcy exemptions that are not based on federal law. For example, Illinois law provides an exemption for assets of “retirement plans” in bankruptcy. Although inherited IRAs with non-spouse beneficiaries are generally regarded as not protected by the Illinois statutory exemption, the status of inherited IRAs in the hands of surviving spouses remains an open question.
How does an inherited IRA work? When an IRA owner dies, an inherited IRA is created by simply changing the title to the existing IRA. For example, if a family trust is the beneficiary, the inherited IRA might be retitled the “Donald Trumpe Family Trust as Beneficiary of the Donald Trumpe Inherited IRA.” Funds do not have to be transferred from the IRA to the beneficiary except as otherwise required by the required minimum distribution (RMD) rules. Bear in mind that if the deceased IRA owner had attained age 70 ½ and had been taking required minimum distributions, any distributions not yet made for the year of the owner’s death will still have to be made to the designated beneficiary by the end of that year.
An inherited IRA is not like the beneficiary’s personal IRA unless the beneficiary is a surviving spouse. A surviving spouse can roll over funds into and out of an inherited IRA. A non-spouse beneficiary cannot although non-spouse beneficiaries can make direct trustee-to-trustee transfers to a different IRA custodian (but be careful – it’s still an inherited IRA, not your IRA, and a non-spouse beneficiary cannot make any additional contributions to it).
Recommendations: Overall, IRA funds dwarf the amount of retirement assets held in employer sponsored retirement plans. Those IRAs will offer tempting targets to creditors when they pass on death to beneficiaries other than a surviving spouse. Consider leaving retirement assets in your employer sponsored plans, where protection from creditors is assured, as long as possible. Alternatively, for assets currently held in an IRA, consider retaining the spouse as the primary beneficiary (that appears to be safe for now) and naming only a spendthrift trust as the alternative beneficiary (this can get complicated, so proceed with caution – and professional advice). Other asset protection strategies may make sense for assets held outside retirement accounts, but carefully consider those options with advice from an experienced tax or benefits advisor.