A few weeks ago, we spoke about the relatively unknown estate planning tool called the IRA Trust (http://themcmasterlawfirm.wordpress.com/2014/06/13/the-ira-trust-the-estate-planning-tool-that-nobody-knows-about/). We mentioned the significant tax and estate planning advantages of the IRA Trust, as well as a few disadvantages and possible obstacles to the creation of an IRA Trust. One of the major advantages of having an IRA Trust is that within the trust document, the “spendthrift provision” provides protection for beneficiaries against creditors of the original IRA participant, thus preventing the creditors from collecting from the beneficiary’s trust share.
So why is this so important, you may ask? Well, because on June 12, 2014, the United States Supreme Court issued its opinion in Clark v. Rameker, 13-299, ruling that inherited IRA accounts are available to creditors in bankruptcy. At issue was a Bankruptcy Code provision that exempts from a debtor’s bankruptcy estate “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.” The Supreme Court determined that inherited IRAs (IRA accounts that are simply passed down through beneficiary designations, i.e., not by an IRA Trust) do not constitute “retirement funds” because the holder of an inherited IRA (i) may never invest additional money into the account; (ii) is required to withdraw money from the account regardless of how far he or she is from retirement; and (iii) may withdraw the entire balance of the account at any time, and use it for any purpose, without penalty. Therefore, inherited IRAs are not covered by the Bankruptcy Code exemption even though they are exempt from current income taxation under the enumerated Internal Revenue Code provisions.
Clark was an appeal from a 7th Circuit decision which had similarly ruled that inherited IRAs were not exempt from a debtor’s bankruptcy estate. In upholding the 7th Circuit’s decision, the Supreme Court evaluated the balance Congress established between the interests of creditors and debtors. Congress permitted an exemption for funds that a debtor would use to meet essential needs in retirement. However, the Court determined that exempting inherited IRAs from a bankruptcy estate would not further this goal.
So what does this mean? This means that the Supreme Court ruling will have a significant impact on an individual’s wealth preservation strategy. For many people, retirement accounts such as traditional IRAs, Roth IRAs and IRA Rollovers represent a substantial portion of their assets. Accordingly, protecting these accounts from the creditors of their beneficiaries is critical. Now that the Supreme Court has determined that these accounts can be attacked by creditors of the beneficiary, it is imperative that alternative strategies be explored in order to provide creditor protection for a non-spouse beneficiary of a retirement account. Essentially, an IRA Trust should be pursued in order to fully protect your beneficiaries from any creditors that may arise out of your estate.
Furthermore, financial advisors should alert clients that it is now more important than ever to use trusts in conjunction with retirement accounts. Such trusts must be drafted carefully in order to preserve the income tax-favored treatment of an inherited IRA. Specifically, the IRA Trust contains a specific “spendthrift” provision that protects each individual beneficiary and their separate trust share from any creditor of the estate. Thus, it is highly beneficial to explore the creation of an IRA Trust with experienced estate planning professionals, such as an attorney and/or a financial advisor.
Additionally, bankruptcy creditors also should take this ruling into account when reviewing a debtor’s bankruptcy petition. Currently, Schedule B—Personal Property does not separately identify inherited IRAs. Creditors should carefully scrutinize IRA accounts listed on a debtor’s bankruptcy petition to ensure an exemption is not being claimed for inherited IRAs. These creditors should also be aware that if a debtor has created an IRA Trust, the assets contained in that IRA trust are untouchable and may not be attacked in order to satisfy the debts of bankruptcy.
In conclusion, the United States Supreme Court has now determined that an inherited IRA account (one that is simply transferred to the beneficiary by the standard beneficiary designations) are now subject to the claims of creditors during a bankruptcy proceeding. It is important to note that this ruling has only extended to bankruptcy proceedings (so far) and is not considered a broad application to all situations (yet!). However, in order to avoid the claims of creditors against your IRA account, in bankruptcy actions or otherwise, it is highly advisable to establish an IRA Trust. Please contact our office if you would like to speak in further detail about the process for establishing an IRA Trust and the optimal estate planning strategy for you!