Generally, IRAs are protected from claims of the contributor’s creditors under federal bankruptcy law, (with the exception of divorce). However, a recent ruling by the Supreme Court peels back this protection at the death of the contributor, leaving the accounts vulnerable to creditor claims at the next generation.
Planning ahead using a trust can cure this vulnerability and keep the accounts in tact as a safety net for your family after your death. In the case of Clark v. Rameker, the Supreme Court announced that inherited IRAs are not “retirement funds” and therefore, are not entitled to protection from bankruptcy claims. For convenience, this article will also refer to all qualified plans as IRAs.
In Clark, Ruth Heffron established an IRA and named her daughter, Heidi Heffron-Clark (Heidi) as the sole beneficiary. When Ruth Heffron died, $450,000.00 passed to Heidi as an inherited IRA. In October of 2010, Heidi and her husband filed for Chapter 7 bankruptcy and identified the inherited IRA from Ruth Heffron as exempt from the bankruptcy estate by categorizing it under the retirement fund exemption.
In response, the bankruptcy trustee and unsecured creditors claimed that the inherited IRA did not fall within the scope of the retirement funds exemption. The case ultimately wound its way through the appeals process to the Supreme Court.
In its decision, the Supreme Court explained that the Bankruptcy Code does not define “retirement funds.” The Court then defined “retirement funds” as “sums of money set aside for the day an individual stops working.”
Therefore, the Court ruled that the inherited IRA could not be characterized as “retirement funds,” and as a result, could be accessed by creditors in a bankruptcy proceeding. This came as a surprising development as prior case law had generally affirmed the creditor protection provided by IRAs.
While the case is unclear as to whether an IRA inherited by a spouse will enjoy protection, it seems likely that a spouse who rolls over the IRA funds into the spouse’s own IRA will still be exempt under federal bankruptcy laws. Such a roll over would be a deposit of money set aside for the day the spouse stops working. However, if the spouse does not opt to roll over the account, we see increased risk that it would then be considered an inherited IRA, and would not be protected from creditors.
In light of the Clark case, retirement account owners should consider additional planning to help protect the safety net that an inherited IRA can provide for their families.
One option is to establish an IRA Trust to shelter the retirement assets. IRA Trusts must be carefully drafted to strictly adhere to all IRS requirements or else an accelerated payout of the account may be required causing “bunching” of income, leading to adverse income tax consequences. IRA Trusts must be valid under state law, irrevocable at death, have identifiable beneficiaries who are individuals, and, if the account is held in a qualified plan, a copy of the trust document must be furnished to the plan by October 31st of the year following the IRA owner’s death.
IRA Trusts can be either Conduit Trusts or Accumulation Trusts. In a Conduit Trust, each distribution received by the trust must be promptly distributed to the beneficiary. In doing so, the Conduit Trust does not accumulate excess IRA distributions inside of the trust. Conduit Trusts may only have one individual as the primary beneficiary. The life expectancy of that beneficiary will determine the required minimum distributions that must be taken on an annual basis.
Accumulation Trusts allow all IRA distributions to build up in the trust. Accumulation Trusts also permit more than one beneficiary. However, the oldest beneficiary’s life expectancy will be used, accelerating the required payouts from the IRA under the IRS’ actuary tables.
Conduit Trusts offer weak creditor protection, because distributions must be distributed to the beneficiary. The money that is required to be distributed to the beneficiary is also accessible to creditors. Though the Conduit Trust protects the inherited retirement account, it will not protect the distributions.
Accumulation Trusts allow retirement account owners to control how and when the inherited IRA account is distributed to beneficiaries, thereby laying the ground work for stronger creditor protection. Because the distributions can be retained by the trust, no distributions are required (which as a consequence would be attachable by creditors).
With the recent ruling of the United States Supreme Court, additional planning is merited to protect accounts from future creditors of their beneficiaries. Retirement owners should give serious consideration to the creation of an IRA Trust.
 In lieu of federal exemptions, a debtor can elect to use state exemptions. If the debtor lives in Arizona, Alaska, Florida, Idaho, Missouri, North Carolina, Ohio, or Texas, the state exemptions currently provide protection. The risks of relying on state exemptions are that it is dependent upon the state where the debtor declaring bankruptcy resides and it requires the debtor to elect state exemptions in bankruptcy to obtain the protection although federal exemptions could be more beneficial toward other assets.