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Inherited IRAs Not Protected – Unless . . .

In Clark v. Rameker (June 12, 2014) the US Supreme Court ruled that inherited IRAs will not be protected against bankruptcy.

Jay Adkisson summarized the background and the result in Forbes:

Ruth Heffron established a traditional IRA in 2000, and then promptly died the following year. At the time of Ruth’s passing, there was $450,000 in the IRA

The sole beneficiary-on-death of Ruth’s IRA was her daughter, Heidi Heffon-Clark. After Ruth passed, Heidi decided to take monthly distributions from the IRA.

Heidi received distributions for 9 years, which brings us to the year 2010 when Heidi and her husband filed for Chapter 7 bankruptcy. In their schedules, the couple listed Heidi’s inherited IRA as being an exempt asset.

The Bankruptcy Trustee (“BKT”) and the couples’ creditors disagreed, and claimed that the funds from the inherited IRA were merely Heidi’s inheritance — and thus became an asset of the Bankruptcy Estate that was subject to distribution to creditors — and were nothing like exempt “retirement funds” within the meaning of federal bankruptcy law . . .

Writing for a unanimous Court, Justice Sotomayor concluded that an inherited IRA is an inheritance and not a retirement plan, and, therefore, it is not protected by the federal bankruptcy code.

Is there a way to protect the IRA your leave your children? Yes. As Jay Adkisson explains:

For planners, however, the work-around is pretty simple: Folks with IRAs who want the balance of the moneys to be protected from their heirs’ creditors should designate a spendthrift trust as the beneficiary of the balance, and not their heirs directly.

Indeed, this decision will probably cause a mini-boom in estate planning, and cause folks with anything like significant amounts in their IRAs to create trusts for their heirs instead of on death leaving those heirs the IRA accounts outright.

But that should be true for any significant asset, not just inherited IRAs. Probably one of the dumbest things one can do is to leave significant assets to their heirs outright, instead of leaving it to their heirs in a spendthrift trust.

Even when debtors don’t have any current assets, it is a common practice for creditors to keep their judgments alive, set alerts in Google for the debtors’ names and the names of their parents, and then wait to see if they inherit any money. I can’t tell you how many times I have seen in my practice where a debtor didn’t have anything, but then somebody died, and the judgment was satisfied out of their inheritance.

Planning to leave assets in spendthrift trusts for children, to keep the assets out of the hands of the childrens’ creditors, has a long and established history in Anglo-American law — Thomas Jefferson created just such a trust for the benefit of one of his daughters, Martha, who married a husband who had financial difficulties. There is nothing slick or sleazy about it, but rather it is just good planning completely sanctioned by the spendthrift laws of each state.

Last year, I wrote about the benefit of using a stand alone retirement plan trust. With this new Supreme  Court ruling, it is even more applicable.


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