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Supreme Court rules inherited IRAs are NOT protected from creditors

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On June 12, 2014 the United States Supreme Court handed down its opinion in Clark v. Rameker, 573 U.S. ____ (2014). The Court held unanimously that retirement funds inherited by a beneficiary from the original plan participant are not considered to be “retirement funds” within the meaning of the federal bankruptcy exemptions found at 11 U.S.C. §522(b)(3)(C). As a result, a debtor’s bankruptcy trustee may consider the inherited IRA to be an asset of the bankruptcy estate, available to satisfy creditors’ claims. This could be a disastrous result if your IRA beneficiary is involved with a bankruptcy, either now or sometime in the future.

Importantly, the Court found that inherited IRAs do not operate the same way as an individual’s own retirement account. A participant’s own IRA is subject to early withdrawal penalties if taken out early, and an inheritor of an IRA must take out distributions from the inherited account either within 5 years of the plan participant’s death, or over the individual beneficiary’s remaining life expectancy as calculated under tables issued by the IRS determining annual Minimum Required Distributions.

Clark v. Rameker argues strongly in favor of setting aside retirement accounts that will pass upon the death of the plan participant into a special type of trust designed to both protect the inheritance from future creditors of the beneficiary, but also to ensure that the trust qualifies as a Designated Beneficiary under IRC §401(a)(9)(e) and the Regulations promulgated under that Section. These are sometimes called Retirement Plan Trusts.

Often, people assume that a spouse or child who inherits an IRA will use the most tax efficient strategy and distribute the IRA over the longest period of tax deferral allowed under the law. This rarely happens as IRAs tend to fall into the category of most inherited assets - more like lottery winnings or "found money" that end up being spent rather than saved for the future.

If a Retirement Plan Trust is right for you will depend on your ultimate planning goals. Generally, the Retirement Trust is established as a third-party trust for a beneficiary and is funded with retirement assets from a plan participant at death. This trust is an irrevocable, third party trust and as a result, third party trust laws will apply. In most jurisdictions a beneficiary under such a trust enjoys substantial protection from claims of future creditors. This is true because the beneficiary did not establish the trust, did not fund the trust with his or her own assets, and cannot modify the terms of the trust. If the beneficiary does not serve as trustee but has an independent trustee with purely discretionary power over trust distributions, the asset protection will be greater still.

In order for a Retirement Trusts to qualify as a "Designated Beneficiary" under IRS rules, it must be carefully drafted. In addition, the Required Minimum Distributions must be taken out annually in order to avoid a possible tax penalty. Charitable beneficiaries, certain distribution standards, and certain powers of appointment all have the potential to cause the trust to fail as a Designated Beneficiary. If this happens, the entire inherited IRA must be withdrawn within 5 years of the plan participant’s death. However, when drafted properly, the Retirement Plan Trust will not only qualify for the stretch-out of the inherited IRA, but it will also safeguard the inherited account from the creditors of the trust’s beneficiary.

The rules surrounding the use of trusts and IRAs are frequently misunderstood. As a result, it is important to work with a qualified estate planning or elder law attorney with experience in the area of inherited IRAs. Financial advisors are often counseled by their firms that trusts and IRAs are incompatible so often there is conflicting advice between the financial advisor and legal professional. Be sure to get all the information before you make a decision.

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