Are Inherited IRAs Protected From Creditors?

By Helena S. Mock, Esq.

What is an "inherited IRA?" If you name as a beneficiary a person who is not your spouse, the IRA passes to your beneficiary as an "inherited IRA." Why does this matter? There are very specific rules governing the tax treatment of IRAs at different periods of time - before the IRA owner attains age 59 ½, between the ages of 59 ½ and 70 ½, after age 70 ½, and upon death. In addition, there are different rules which apply to the tax treatment of an IRA depending on whom the beneficiary is. For example, if the beneficiary is a trust, the trust must contain special language which will qualify the trust as a "designated beneficiary." If a charity is named as beneficiary, the charity doesn't pay any tax on the IRA, but the funds must be distributed out to the charity before September 30th of the year following the account owner's year of death. If a spouse is named as beneficiary, the spouse can make an election to treat the IRA as his own, and even comingle with an existing IRA of the spouse, thus affording the spouse the same level of access, control, and creditor protection as he enjoys with his own IRA. This election is referred to as a "spousal rollover," and it is only available to spouses. When a child or other individual is named as beneficiary, the IRA is treated as an "inherited IRA" and very different rules apply regarding distribution and taxation. With an inherited IRA, the deceased owner's name remains on the account which is set up "for the benefit of" or "fbo" the beneficiary. A traditional account designation for an inherited IRA would read something like: "John J. Smith Inherited IRA fbo Susie Smith Jones." This account designation tells the world that this is an inherited IRA and thus subject to a different set of rules.

There are some notable characteristics of inherited IRAs which distinguish them from an individual's own retirement fund. First of all, the beneficiary of an inherited IRA must begin taking the required minimum distribution (RMD) from the IRA by December 31st of the year following the year of death. In other words, the beneficiary does not get to wait until attaining age 70 ½, and there is no penalty for making withdrawals prior to the age of 59 ½. Second, no additional money can be added to an inherited IRA and an inherited IRA cannot be combined with any other IRA of the beneficiary. Third, and this is one of the more positive features of inherited IRAs, although the beneficiary must begin taking distributions, the RMD is based on the beneficiary's life expectancy, not that of the deceased account owner. This means that if the beneficiary is younger than the account owner, the IRA will be paid out over a longer period of time, thus providing the opportunity for maximum deferral on the payment of income tax. This is commonly referred to as a "stretch IRA."

A beneficiary of an inherited IRA can still name her own beneficiary of any funds remaining in the IRA at her death. However, once the beneficiary of the inherited IRA dies, the required minimum distributions do not re-calculate, and the new beneficiary must continue to receive distributions based on the prior beneficiary's remaining life expectancy.

But is an inherited IRA protected from creditors of the beneficiary? Over the past ten years or so, this issue has been the subject of numerous cases. The issue has primarily been addressed within the context of a beneficiary's request for protection under federal bankruptcy laws.

In 2014, the U.S. Supreme Court finally settled the issue for purposes of federal bankruptcy law by holding in Clark v. Rameker, 573 U.S. ___ (2014) that retirement funds lose their character after the death of the original owner and become merely inherited assets which are not permitted any special protection under the Bankruptcy Code. In rendering its decision, the Supreme Court reviewed the legal characteristics of regular versus inherited IRAs and found inherited IRAs to be distinct from "retirement funds" based on the unique characteristics defined above. Based on these characteristics, the Court held that an inherited IRA is no more than any other inherited account which is intended for "current consumption" rather than retirement savings.

The follow-up question, however, is whether an inherited IRA is protected from creditors in non-bankruptcy situations? Obviously if the case is brought under federal law, the Supreme Court's holding in Clark will apply and permit the plaintiff to reach the inherited IRA. In a state court, however, the answer must be found under state law.

Virginia Code Section 34-34B provides in part "the interest of an individual under a retirement plan shall be exempt from creditor process to the same extent permitted under federal bankruptcy law for such a plan." Since the statute references federal bankruptcy law, which now definitively does not exclude inherited IRAs, it would seem the matter is settled. However, the provision goes on to state "[t]he exemption provided by this section shall be available whether such individual has an interest in the retirement plan as a participant, beneficiary, contingent annuitant, alternate payee, or otherwise." (Emphasis added).

The statute has not been amended since the Clark decision was handed down by the Supreme Court, so we really have no answer to the question. So how can you be sure the retirement plan assets you leave to your children are protected from lawsuits and other creditors (including spouses in a divorce proceeding)? The only way to be sure is to name a trust for the child as beneficiary rather than naming the child as a direct beneficiary. There are many options available, and of course there are tax consequences to be considered, but today this is the only sure way to ensure that the funds will be protected.

As a trust cannot "own" or hold title to an IRA, the only way to ensure the protection afforded by a trust is to name the trust as beneficiary. A stand-alone trust, commonly referred to as a Retirement Preservation Trust, can qualify as a designated beneficiary of IRA proceeds, but it is not necessary to use a stand-alone trust in order to obtain creditor protection. As with everything else within the realm of what we refer to as "estate planning," there is no "one-size-fits-all" plan.

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