Since the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005, individual retirement accounts have been protected under federal law. This meant that if an owner declared bankruptcy, up to $1,245,475 in IRA assets were protected from creditors. As of the unanimous ruling of the Supreme Court on June 12, 2014, this may no longer be the case.
The Bankruptcy Abuse Prevention and Consumer Protection Act was enacted to protect personal IRA accounts. Federal courts, however, have long been divided over whether inherited IRA’s are protected under this act too. The Supreme Court’s ruling in June means that unless states have direct laws addressing this issue, these IRAs are vulnerable. States that have adopted laws exempting inherited IRAs from creditors in bankruptcy include Alaska, Arizona, Florida, Missouri, North Carolina, Ohio and Texas. If this isn’t where your named beneficiary lives, now is the time to seek other ways to protect retirement funds after death. This ruling presents a good opportunity for all Individual Retirement Account owners to review their beneficiary designations, and adjust titling where needed to ensure the best protection of their hard earned funds long after they’re gone.
As of now, spousal beneficiaries are not in the crosshairs of this argument; and there are many good reasons supporting this. How an IRA is treated when inherited from a spouse is very different than that of other beneficiaries. When you inherit an IRA from a deceased spouse, you are the sole beneficiary and entitled to treat the IRA as your own. By doing this, it would no longer be regarded as an inherited IRA for bankruptcy purposes. The ability to make the IRA your own makes sense because during a marriage, couples make decisions for the betterment of their family. These decisions include whether it is beneficial for one member to work part-time, or even not at all for a period of time. This creates the argument that regardless of how an IRA is titled, it is “joint” money and for this reason, it is not included in the Supreme Court decision.
Beneficiary Designation IRAs
In June, the Court decided in the Clark v. Rameker case that inherited non-spousal IRAs are not protected retirement funds under federal law. The reasons for their decision are not without merit. First, a non-spousal beneficiary cannot treat the inherited IRA like it was their own. You cannot add new money to the account, and you can withdraw the entire balance at any time without early distribution penalties. Beneficiary Designation accounts must take mandatory distributions from the account each year, regardless of whether the owner is 20 or 70, until all the funds are fully dispensed. So in other words, it doesn’t look, feel or behave like a traditional IRA.
Unless an owner of an inherited IRA resides in Alaska, Arizona, Florida, Missouri, North Carolina, Ohio or Texas, there is no longer protection for inherited IRA assets in bankruptcy. This means it is now easier for creditors and bankruptcy attorneys to make claim on inherited assets in order to settle outstanding debts. Since the ruling in June, IRA owner’s are reviewing named beneficiaries and looking for ways to keep their hard earned money out of the hands of their beneficiaries’ creditors.
Fortunately, most people feel secure that their IRAs will be good hands after their passing. But for even the most secure family, unfortunate things in life happen. For residents of states that do not have inherited IRA protection, there are other ways to safeguard funds after death. One way is to name a trust as beneficiary. If drafted right, this trust would protect trust assets from the beneficiary’s creditors, and replicate the feature of a Beneficiary Designation IRA that would slowly distribute money annually. The downside is that trusts are not particularly tax friendly because they generally have a much higher tax rate attached to them. It is extremely important to consult qualified professionals before making this decision. An estate attorney or a tax consultant specializing in estate tax laws, along with a financial advisor with estate designations is a good first step. They can help determine whether options like a trust, Roth conversion during an owner’s lifetime, or even using IRA money for life insurance left to a trust makes the most sense.
Without a doubt the Supreme Court’s decision may end up being a game changer when it comes to estate planning. Now that IRAs are no longer bulletproof from creditors, other strategies may need to be considered if an owner views a beneficiary’s situation to be precarious. If you have an Individual Retirement Account with a non-spouse beneficiary, take time to review the various options to enhance creditor protection. This will give you peace of mind that your assets will be safe for the next generation.