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Supreme Ct: Inherited IRA not protected in bankruptcy

6-12-2014 - An inherited IRA does not have the same bankruptcy protection as a non-inherited IRA, the U.S. Supreme Court has decided. The unanimous June 12, 2014 decision in Clark v. Rameker has far-reaching estate planning implications. An IRA is often one of, if not the largest, asset in an estate. If you intend to leave your IRA to your children, you should take steps without delay to protect the funds from your child's creditors in the event your child goes through a bankruptcy in the future. 

Clark v. Rameker concerned a $300,000 IRA that Heidi Clark-Heffron inherited from her mother when her mother died. When Clark-Heffron's business subsequently failed, she filed for bankruptcy under Chapter 7. She argued that the IRA she had inherited was a retirement account and thus protected from creditors under federal bankruptcy law. The Supreme Court ruled against her, concluding that an IRA inherited by a non-spouse is not, effectively, a "retirement account." Unlike an IRA a person sets up, contributes to and withdraws from at retirement age, or one passed to a spouse and rolled over by the spouse, the funds in an inherited IRA may be withdrawn without penalty at any time before retirement age. Thus, an inherited IRA has effectively lost its status as a retirement account and is simply a "pot of money" that does not merit any special protections, the court determined.

The Supreme Court decision says that the IRA you leave your non-spouse beneficiary will be available to his/her creditors should the beneficiary file for bankruptcy. However, a grey area exists that must still be clarified with regard to beneficiaries who reside in Florida. Fortunately, notwithstanding this grey area, proper estate planning can protect an inherited IRA regardless of where the beneficiary resides, as is explained below.

Here is the grey area: Florida statutes exempt inherited IRAs from creditor claims. Of course, this protection applies only to beneficiaries who reside in Florida. (We do not know what other states, if any, provide similar protection.) On the other hand, bankruptcy laws are federal rules that govern whether debts will be discharged in bankruptcy. The unanswered question is: If a Florida resident who owns an inherited IRA files for bankruptcy, will the federal bankruptcy court allow the discharge of debts, if the beneficiary retains the IRA?

This may sound confusing, but the fundamental problem is that there are two different and distinct issues at play. One: Can a creditor attach a Florida resident's inherited IRA? Clearly, the answer is no. Two: Can a debtor who resides in Florida be discharged in bankruptcy while retaining an inherited IRA? That is the question that has yet to be answered by the courts. Several experts in bankruptcy law say they are uncertain what the courts will hold.

Regardless of what the courts ultimately decide, or where your child resides (in a state that provides IRA beneficiary protection or not), there are steps you can take to protect the IRA funds you pass to your beneficiary. Here's the key: Do not make your child the beneficiary of your IRA. Instead, leave it in a spendthrift trust for your child. A properly drafted IRA Trust or IRA Stretchout Trust can accomplish this goal. Do not rely on a traditional revocable living trust to accomplish that goal! 


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