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Funds in inherited IRAs are not protected from bankruptcy.
Thanks to the U.S. Supreme Court decision in Clark v. Rameker, a key ambiguity in bankruptcy law has been resolved. Unfortunately for those who face bankruptcy proceedings and were hoping to keep funds in an inherited IRA, the ambiguity was not resolved in their favor.
This does not mean that the IRAs that you set up and fund yourself, either through annual contributions or by rolling over assets from a company plan, are unprotected in bankruptcy proceedings during your life. The decision only applies to funds in an inherited IRA and the bankruptcy proceedings of the beneficiary of those IRA funds.
There are several features to inherited IRAs that make them unique and suggest that they are not retirement assets. Unlike IRA owners, inheritors cannot put additional funds into the account, but they can take out money at any time without penalty. Generally speaking, non-spousal IRA heirs must either take out a minimum amount each year, starting by December 31 of the year after the IRA owner died, or must withdraw the entire account balance within five years of the original owner’s death. This is true regardless of whether the IRA is a traditional IRA or a Roth.
The Court noted in the decision that the IRA system’s design, which is to ensure that the owners of the IRA will have money available during retirement, justifies protection of the assets during bankruptcy.
Despite of the Court’s decision, there are some strategies that IRA inheritors may consider to protect the IRA funds:
Spouses – Spouses who inherit an IRA have an option not available to other inheritors.
Let’s assume Mary inherits her husband Tom’s IRA. Mary can roll the assets into his or her own IRA and postpone distributions from a traditional IRA until she turns 70½. However, like other IRA owners Mary may have to pay a 10% early-withdrawal penalty if she takes money before age 59½ from her own IRA.
If Mary does not rollover the assets the account is considered an inherited IRA, and she would not have to take any money out until Tom would have turned 70½. But thanks to the Court’s decision those assets would not be protected in bankruptcy.
Trusts – Another option is to name a rust instead of a person as the beneficiary of an IRA. This strategy can be used to benefit a spouse or anyone else, and has been a popular estate planning strategy to protect IRA assets from creditors before the Court’s decision. However, there are complex rules involved in this approach, so it is best to consult an experienced professional before choosing this option.
By Eric J. Einhart – Guest Blogger