Question: The recent Supreme Court decision regarding inherited IRAs seems to have suddenly made our IRA beneficiary designations obsolete. Now what? As always, I appreciate your wisdom and thoughts on these financial and estate planning issues.
Answer: When is an Individual Retirement Account (IRA) not a retirement account? “When it’s an inherited IRA,” according to the Supreme Court. Here’s the story:
Ruth named her daughter Heidi, a resident of Wisconsin, as the beneficiary of her IRA. Ruth died in 2001 with an IRA worth about $450,000. Heidi set up an inherited IRA and started taking mandatory distributions as required by the IRS. In 2010 Heidi’s inherited IRA was worth about $300,000 when she and her husband filed for bankruptcy. Heidi claimed her inherited IRA was protected from creditors because it consisted of retirement funds. When Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) in 2005, which was designed to make bankruptcy less attractive, they included some protection for retirement funds; BAPCPA exempted $1 million of IRA money from bankruptcy ($1,245,375 today after inflation adjustments).
Heidi’s creditors challenged the exempt status of the inherited IRA by arguing that it did not qualify as a retirement fund and was therefore not exempt from the estate. At this point, Heidi was probably dumbfounded, asking herself how an individual retirement account cannot be a retirement account. The bankruptcy court’s answer was because the funds are not set aside for retirement and not distributed at retirement, which is true. (Non-spousal IRA beneficiaries, regardless of age, must begin taking required distributions in the year after the death of the IRA owner.)
Upon appeal, the district court reversed the bankruptcy court’s decision and said IRAs are retirement funds and they are exempt. Upon further appeal, the 7th Circuit Court agreed with the bankruptcy court that inherited IRAs are not retirement funds. This 7th Circuit Court decision conflicted with a 2012 5th Circuit Court decision stating that inherited IRAs were exempt because “the defining characteristic of retirement funds is the purpose they are ‘set apart’ for, not what happens after they are ‘set apart.'”
This conflict between Circuit Courts got the attention of the Supreme Court, who ruled unanimously on June 12th, 2014 that assets held under an inherited IRA by a non-spouse beneficiary are not “retirement funds” and therefore not protected by bankruptcy laws. So how does this affect you? Here is what you need to know:
1. Inherited IRAs in states like California that do not have bankruptcy exemption statutes protecting inherited retirement accounts will not be protected from creditors in bankruptcy. Florida, Arizona, Alaska, and Texas do provide creditor exemption for assets held in an inherited IRA.
2. If your spouse inherits your IRA and rolls it over into her own IRA, it will most likely be deemed a retirement account and be protected from creditors in bankruptcy; however, the Supreme Court did not specifically say that.
If you are concerned that your children or other non-spouse beneficiaries might someday file for bankruptcy, and if they don’t live in Florida, Arizona, Alaska, or Texas, and you want to protect your inherited IRA from creditors, see your attorney and consider replacing them as beneficiaries with a properly drafted spendthrift “Accumulation Trust” or “Conduit Trust.”
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.