THE US SUPREME COURT RULES THAT INHERITED IRAS ARE NOT PROTECTED IN BANKRUPTCY, HOWEVER, STATE LAW MAY OVERRULE THAT!
When an individual files for bankruptcy, the Federal Bankruptcy Code permits the debtor to exclude certain types of assets from the “bankruptcy estate” and thus protect them from his or her creditors. One of the types of assets excluded from the estate are “retirement funds” (11 U.S.C. x 522(b)(3)(C)). On June 12, the US Supreme Court ruled that inherited IRAs are not “retirement funds” and thus are not excluded from being counted by the Bankruptcy trustee as assets available to creditors claiming against the estate.
To determine what types of assets are excluded, either the Federal Bankruptcy Code or state law applies. In Idaho, state law determines what can be excluded (Idaho Code 11-609.) Idaho law also provides that inherited IRAs are exempt from all claims arising from claims of judgment creditors of the beneficiary arising out of a negligent or otherwise wrongful act or omission of the beneficiary resulting in monetary damages to the judgment creditor. (Idaho Code x 55-1011).
Therefore if Idaho is a debtor’s domicile when he or she files for bankruptcy, Idaho law can control whether an inherited IRA is part of the bankruptcy estate or not.
Nevertheless, when a person name an individual as a beneficiary of his or her IRA, there can be no assurance that if the beneficiary later files for bankruptcy, that he or she will still be in Idaho or in another state at that time that has: (1) “opted out” of the Federal Bankruptcy Code’s definition of excluded assets and (2) protects inherited IRAs from judgment creditors. Therefore, if the inherited IRA is potentially quite large, it might be a safer course of action to name a trust as the beneficiary of the IRA rather than an individual outright.
There are complex rules governing how a trust must be drafted and administered in order for it to be a “designated beneficiary” such that the IRA is not required to be distributed to the estate of the owner and thus lose the benefit of tax deferral over multiple years. One type of trust that can qualify, and also protect its assets from beneficiaries' creditors, is one that accumulates the minimum required annual distributions and all other IRA distributions for the beneficiaries and only distribute trust assets in the sole discretion of the trustee.
However, in order for such a trust to be determined a qualified beneficiary such that the IRA is not paid out to the owner’s estate, and have its assets creditor protected, it must: (1) be listed on the beneficiary designation form as the IRA beneficiary; (2) be valid under state law; (3) be irrevocable at least by the date of the owner’s death; (4) only have individuals as beneficiaries of the trust all of whom can be indentified by September 1 in the year following the IRA owner’s death; and (5) trust documentation must be given to the IRA custodian by October 1 of the year following the IRA owner’s death.
Additional challenges with respect to such trusts are first, that trusts are taxed as the highest rate of tax on income and capital gains retained in the trust when the total earned reaches $11,900.00 (in 2013). Second, there are complicated rules regarding whose life expectancy among all the beneficiaries determines the annual minimum distributions from the IRA.
Creditor protection and estate planning are complicated matters that must reflect the specific circumstances of an individual and his or her family. If you, like so many Americans, own IRAs and the IRAs that are of significant size, we urge you to consult with your estate planning lawyer to determine the best course of action for you to protect your hard earned money from potential creditors or bankruptcy of your loved ones named as beneficiaries of your IRAs.
For more information, contact Mathieu, Ranum & Allaire, PLLC
Disclaimer: The foregoing is NOT legal advice. We have prepared these materials to inform and educate. They are not, and should not be considered, legal opinions or advice to anyone, nor do they create an attorney client relationship by your reading them. These materials may not reflect the most current legal developments in the applicable area of law. Furthermore, this information should in no way be taken as an indication of future results.