Supreme Court Ruling Strips Bankruptcy Protection From Inherited Retirement Accounts

Imagine this:  you’ve worked hard to save money in your IRA or 401(k) that will someday be left to your spouse or children upon your passing.

You do the right thing by hand selecting beneficiaries and rest easy knowing the money will be safe for heirs after you are gone.

Years later, your child inherits your retirement account, and is soon laid off from work.  A new job is proving difficult to find and bills are spiraling out of control.  The only way out is to file bankruptcy, which the child does, believing the retirement account will at least be there as a nest egg during hard times ahead.

After all, 401(k)s and IRAs are generally considered “off limits” if an account holder files for bankruptcy.  This helps to ensure that the individual has enough money for retirement, despite any current financial troubles.  Surely an inherited retirement account will be afforded this same protection…right?

Maybe not.

Inherited IRAs Lose Bankruptcy Protection

For decades, courts across the country have struggled to determine if inherited retirement accounts should be afforded the same bankruptcy protection as traditional IRAs.

The Supreme Court recently put an end to all the confusion in the case of Clark v. Ramaker by ruling that inherited IRAs are not actually “retirement funds” within the meaning of federal bankruptcy law.  The court cited three major differences between traditional IRAs and those that are inherited:

  • The beneficiary of an inherited IRA cannot make additional contributions to the account, while an IRA owner can.
  • The beneficiary of an inherited IRA must take minimum distributions from the account regardless of how far away the beneficiary is from actually retiring, while an IRA owner can defer distributions until age 70 ½.
  • The beneficiary of an inherited IRA can withdraw all of the funds at any time and for any purpose without a penalty, while an IRA owner must generally wait until age 59 ½ to take penalty-free distributions.

Simply put:  although an inherited IRA may at one time have been created as a “retirement account,” the beneficiary does not have to use it for that purpose in states which rely on federal bankruptcy exemptions and may or may not have that protection here in Georgia in the future.

There is nothing stopping the beneficiary from withdrawing the funds at any time to finance luxury vacations, new cars, a home or any other purchase.  Since the inherited IRA can be used as discretionary income, the Court held that it is not actually a “retirement account” per se, and the funds can be used to satisfy creditors’ claims if a beneficiary files bankruptcy in states using federal bankruptcy exemptions.  In Georgia, where there are state statutory bankruptcy exemptions, the long-term effects of this ruling are less clear.

A Real-Life Example of Savings and Loss

The possibility of losing an inherited retirement account in this manner is more common than you might expect.  Take for example the case of Joan and Robert.  Robert worked hard to save for retirement, accumulating $450,000 in his 401(k).  Unfortunately he was also diagnosed with a serious medical condition and accumulated over $300,000 in medical debt before he passed away.

After his death, his wife transferred the funds of the retirement account into an “inherited” IRA so that she could access the money without having to pay a 10% penalty before age 59 ½.  That money was her lifeline.

However, the medical bills spiraled out of control and were eventually turned over to a collection agency.  Unable to pay back the balance, Joan was forced into bankruptcy. Little did she know that the money in her “inherited” IRA could now be seized by creditors during the bankruptcy proceedings.  Had Robert planned for this possibility, the funds would have stayed protected.

Protecting Wealth In An IRA For Beneficiaries

It is common for estate planning lawyers to see clients who have much of their wealth in the form of an IRA or 401(k). It often makes up a large part of the estate they intend to leave behind. Now, however, if a beneficiary declares bankruptcy, that money may be in jeopardy, especially if one or more beneficiaries live in other states.

In order to protect a retirement account for heirs or a surviving spouse, many estate planning lawyers are recommending clients to set up a

Standalone Retirement Trust.

This legal tool makes the money inaccessible to any future creditors of the trust’s beneficiary because the trust was not established or funded by the beneficiary.

Remember, if the account is not in the beneficiary’s name, it can’t be seized!  And, when done properly, the trust’s distributions can be made similarly to how they would have been distributed from the IRA without the risk from the beneficiary’s creditors.

Plan Now to Avoid Trouble Later

Utilizing a Standalone Retirement Trust is a smart way to ensure that the tax-deferred plan you worked so hard to accumulate will not be lost should a beneficiary fall into financial hard times.  Talk to an estate planning professional about planning strategies for retirement accounts for the peace of mind knowing that your money will be protected for those you leave behind.


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