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IRAs are excellent tools for accumulating tax-deferred (or, in the case of Roth IRAs, tax-free) retirement savings. They are also popular because, under the “retirement funds” exemption of federal bankruptcy law, they are protected from creditors.

An inherited IRA can have a significant tax downside, since in the case of a tax-deferred IRA the IRS will collect taxes on the deceased’s deferred income and gains from the beneficiary, but it was until recently presumed to extend the original asset protection to the beneficiary. Thanks to a recent U.S. Supreme Court decision, that is no longer the case in many states.

In 2014, the Supreme Court upheld a lower court decision that inherited IRAs are not protected from creditors in bankruptcy proceedings under federal law (Clark v. Rameker, No. 13–299, June 2014). According to the high court, it ceases to be “retirement funds” in the hands of the beneficiary and thus loses the protection afforded to IRAs under Section 522(b)(3)(c) of the Bankruptcy Code. 

The landmark case began in 2010 when a Wisconsin pizza shop owner, Heidi Heffron-Clark, and her husband filed for bankruptcy protection after their business closed. The Clarks’ largest asset was an IRA that Heidi had inherited from her mother, which was worth $450,000 at the time of her mother’s death.

In their filing, the Clarks listed the IRA as an exempt asset from bankruptcy using the “retirement funds” exemption. The bankruptcy trustee disagreed, and the case eventually reached the U.S. Supreme Court. 

In analyzing the exemption, the Supreme Court defined “retirement funds” as “sums of money set aside for the day an individual stops working.” The Court then examined the characteristics of inherited IRAs and concluded that they are distinct from other retirement accounts in three notable ways.

  • First, beneficiaries cannot add money to an inherited IRA for retirement.
  • Second, they generally must take required minimum distributions (RMDs) from the inherited IRA regardless of how far they are from retirement age.
  • Third, beneficiaries can withdraw additional money exceeding the RMDs from an inherited IRA at any time and for any purpose without penalty.

Based on these characteristics, the Court concluded that an inherited IRA is not a “retirement fund” and should not be exempt from the claims of creditors in bankruptcy. As Justice Sonia Sotomayor wrote in the Court’s unanimous opinion, “Nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete.”

The Supreme Court’s decision has important ramifications for clients who plan to leave large IRA balances to their beneficiaries in the hopes of extending the tax-deferral benefits of an IRA over many more years. It may also impact married individuals who inherit an IRA from a spouse. 

While the Court did not specifically address IRAs that are inherited by a spouse, there are special rules under the current tax code that may afford a level of protection, including the ability for a surviving spouse to roll over a decedent’s IRA into his or her own IRA. A rollover would enable the surviving spouse to postpone distributions and continue the tax-deferred growth of the inherited funds until he or she turns 70½. And while the Court did not rule specifically on the impact of a spousal rollover on creditor protection, a rolled-over IRA should arguably have the same level of protection as when it was in the original owner’s hands under the Court’s reasoning.

Fortunately for Florida residents, its laws specifically protect inherited IRAs from creditors and allow people to opt out of the federal bankruptcy exemptions in favor of their own. IRA beneficiaries who live in Florida, or in another state with similar protections, and file for bankruptcy should be able to exempt their inherited IRAs. However, it is the state of the beneficiary’s domicile that will determine if this protection is available. A Florida retiree who leaves an inherited IRA to beneficiaries who live in other states will not extend Florida’s protections to the beneficiaries.

An additional option to safeguard IRA assets from creditors is to name a trust, rather than a person, as the beneficiary of the IRA. Although it has not been fully tested in the courts, an IRA left to an irrevocable “retirement benefits trust” may have a better chance of being protected from the claims of the new account owner’s creditors and also from the claims of creditors of the trust beneficiaries. Using a trust can also provide other important benefits. These includes using the oldest beneficiary’s life expectancy to stretch out the tax-deferred growth; control over when the beneficiaries will receive distributions; the ability to provide for special needs beneficiaries; and a way to protect the asset from future lawsuits, irresponsible spending and divorce proceedings. 

Everyone’s situation is different, and you should make sure to consult with a qualified professional when formulating your estate plan. The Supreme Court’s ruling in Clark v. Rameker simply underscores the importance of getting up-to-date advice from a legal professional who understands the nuances of protecting and passing on wealth to loved ones.