Should You Avoid Leaving Your IRA to Beneficiaries Who Are Considering Bankruptcy?

The short answer: possibly, depending on where your beneficiaries are located.

Over the summer, the U.S. Supreme Court took on the question of whether or not an inherited IRA is exempt from a debtor’s bankruptcy estate in Clark v. Rameker. The Supreme Court held–unanimously–that an inherited IRA is not exempt from a debtor’s bankruptcy estate, at least as far as federal law was concerned (we’ll come back to this later).

Here’s what happened:

Ms. Clark was named as the beneficiary of her mother’s IRA. When Ms. Clark’s mother died in 2001, the IRA was worth about $450,000, and Ms. Clark began taking distributions from the IRA.

Fast-forward to 2010, when Ms. Clark and her husband filed for Chapter 7 bankruptcy. At this point, the inherited IRA was down to about $300,000. As part of the bankruptcy process, the property that belongs to the debtor is gathered, and as I understand Chapter 7 (I don’t practice bankruptcy, so if you’ve got a question about that, I’d recommend you get in touch with a bankruptcy attorney), everything that isn’t protected by an exemption is liquidated and used to pay off creditors. The debtor’s debts are otherwise eliminated, and the debtor gets to keep the exempt property.

And that’s the dispute: the bankruptcy trustee argued that the inherited IRA ought to be part of the estate used to pay the creditors. Ms. Clark countered that under § 522(b)(3)(C) of the Bankruptcy Code, which exempts retirement funds from the bankruptcy estate, she should get to keep the inherited IRA.

Ms. Clark lost. The Supreme Court held that Ms. Clark’s inherited IRA did not count as “retirement funds,” so it was part of the bankruptcy estate, and the proceeds left in the account went to Ms. Clark’s creditors. The Supreme Court raised three reasons why inherited IRAs aren’t retirement funds like your everyday traditional or Roth IRA:

  • The owner of an inherited IRA isn’t allowed to invest money in the account, so it isn’t useful as a vehicle to save for retirement;
  • The owner of an inherited IRA is required to withdraw money from the account, no matter that person’s age or how close he or she is to retirement; and
  • The owner of an inherited IRA is allowed to withdraw the entire balance of the account at any time without penalty. This isn’t true of traditional or Roth IRAs, where an owner that withdraws funds prior to reaching age 59 1/2 may face a 10% early distribution penalty.

One wrinkle to the inheriting of IRAs is that a spousal beneficiary has the option to treat the IRA as his or her own. In that instance, the IRA would be treated as if the beneficiary were the account holder all along, and may contribute to the account, cannot take death distributions, and could be liable for a 10% premature distribution penalty for withdrawals made prior reaching age 59 1/2. The Court didn’t address it directly (and it didn’t need to in order to reach a decision), but under the Court’s reasoning, an IRA that a spouse is treating as his or her own is probably still “retirement funds” under the federal bankruptcy code.

So why does it matter where the beneficiary lives?

Some states have their own rules for what can be protected from creditors. In a handful of states, including Missouri, inherited IRAs are specifically protected from creditors. It’s important to remember here that if you’re investing in an IRA, it doesn’t matter where you live. What matters is where your beneficiary lives when he or she declares bankruptcy. Because people move around a lot, and laws change frequently, it may be difficult to predict if this ruling will affect your beneficiaries or not.

If you’re concerned that this might be an issue, you may want to consider leaving the beneficiary’s share of the IRA in trust. Specifically, the trust involved is known as a “spendthrift trust,” which is a trust with language that restricts the beneficiary’s ability to transfer his or her interest in the trust. Another option might be to leave other property that might count as exempt under the laws of the beneficiary’s estate.

This is a good reminder that things change, and it’s a good idea to review your estate plan from time to time in order to detect these sorts of problems.

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