Protecting Inherited IRAs from Creditors

Who do you plan to leave your individual retirement account (IRA) to when you’re gone? If you plan to leave it to a beneficiary other than your spouse, your beneficiary’s “inherited IRA” may be exposed to creditors. Earlier this year, the Supreme Court ruled in Clark v. Rameker that inherited IRAs are not shielded from bankruptcy creditors. However, a properly structured accumulation trust may protect an inherited IRA.

Bankruptcy and creditor protection

The Supreme Court, in its June 12, 2014, ruling, held that the inherited IRA of the account owner’s daughter did not meet the definition of a retirement fund and, therefore, the IRA was not protected in the daughter’s bankruptcy. Although somewhat uncertain, most experts believe that the Court’s holding does not extend to IRAs rolled over by surviving spouses. Thus, spousal rollover IRAs appear to be protected in bankruptcy, but IRAs inherited by children and other non-spouses are generally exposed to creditors.

Some states, including Florida, have opted out of the federal bankruptcy rules and have adopted their own exemptions for inherited IRAs. A beneficiary residing in one of these states (for at least two years prior to filing a bankruptcy petition) may elect to use the state law exemptions, thereby protecting the inherited IRA. Unfortunately, when designating beneficiaries for an IRA, the owner will not be certain where the beneficiaries will reside in the future. If, for example, a child residing in Florida moves to another state, the inherited IRA could become exposed to creditors under the federal rules.

Accumulation trusts to the rescue

Accumulation trusts can be structured to protect inherited IRAs from creditors regardless of the beneficiary’s state of residence.

Instead of designating one or more individuals as beneficiaries of an IRA, the IRA owner may designate accumulation trusts for the benefit of those individuals. Each beneficiary’s trust would receive required minimum distributions (RMDs) from his or her inherited IRA, along with any additional IRA distributions the trustee decides to take. The trustee would have the discretion to distribute funds to the beneficiary, to pay expenses on the beneficiary’s behalf or to accumulate and reinvest funds in the trust.

The trusts can be created under the IRA owner’s will or revocable trust and can spring to life upon the IRA owner’s death. In other words, the trusts do not have to be created or maintained during the owner’s lifetime.

If properly structured, the trust assets, which can include the beneficiary’s inherited IRA as well as other assets inherited from the IRA owner, would likely be protected from the beneficiary’s creditors.  Moreover, the trust assets may also be protected from potential divorce claims against the beneficiary, or even from the beneficiary himself, who might otherwise be inclined to immediately liquidate the inherited IRA.  Furthermore, the assets of the trust would not be included in the beneficiary’s estate upon his or her death, thereby avoiding estate taxes that might otherwise be due if the beneficiary owned the inherited IRA free of trust.

An accumulation trust can be structured to qualify an inherited IRA for the income tax deferral benefits that are available to individuals, but care must be taken in drafting the trust. For example, each beneficiary should receive a separate trust. If a trust has multiple current beneficiaries, the age of the oldest beneficiary must be used when computing the RMDs, which fails to maximize the tax deferral.

As a result of the Supreme Court’s ruling in Clark, retirement account owners who wish to leave their IRAs to individuals other than their spouses may want to consider designating accumulation trusts as beneficiaries. Even if the individual beneficiaries currently reside in Florida, accumulation trusts may provide additional creditor protection if the beneficiaries move to another state.