In a unanimous decision the Supreme Court has ruled that an IRA is not protected from creditors in bankruptcy proceedings when it is inherited in an estate. In the case of Clark v. Rameker, Heidi Heffron-Clark inherited an IRA from her mother in 2001. The account contained roughly $450,000 and she began to make distributions. In 2010, Mrs. Heffron-Clark and her husband filed for bankruptcy, but they claimed that the remaining $300,000 in the account was shielded from creditors as retirement funds. The creditors and bankruptcy court disagreed, and the case went all of the way up to the Supreme Court.
Key Distinctions of Inherited IRAs
The Court made its decision that inherited IRA accounts are subject to bankruptcy and creditors based on a couple of specific differences between inherited IRAs and owner IRA accounts. Owners of an inherited IRA cannot put additional funds into the account. Additionally, they can take distributions from the account at any time without penalty. In fact, the law states that an heir to an IRA account must either withdraw the entire amount from the account within five years of the original owner’s death or at the very least take out a minimum amount starting the December 31st after the original owner died. This applies to regular and Roth IRA accounts.
Inherited IRAs differ from IRA owner accounts because the purpose of an IRA is to ensure that retirement funds will be available in your elder years. If an IRA is inherited, the original owner clearly no longer needs those funds for his retirement, and therefore the need for bankruptcy protection of those assets no longer applies.
Ramifications on Estate Planning
This decision does have some effect on estate planning. First and foremost, it is important to remember that IRAs are typically not covered in a will. When an IRA or other employer-sponsored retirement fund is created the owner of the account must fill out a beneficiary designation form. This form can later be amended, but the account is inherited by the person named on this legal document.
Spouses face the biggest consequences from the decision in Clark. A spouse that inherits an IRA has the option to rollover the inherited account into her own IRA. Distributions from her IRA are postponed until the spouse turns 70½, and penalties apply if the spouse takes the IRA early. If a spouse elects not to rollover the IRA, it is considered an inherited account and is now subject to bankruptcy proceedings.
Besides rolling over the account another option for avoiding an inherited IRA being subject to bankruptcy proceedings is to name a trust, as opposed to a person, as the beneficiary of the IRA. With the advent of the decision in Clark we are likely to see an increasing number of account owners naming trusts as the IRA beneficiary and having their loved ones named as beneficiaries to the trust. However, setting up IRA beneficiaries as a trust is a complicated legal issue, and if you elect this option the best decision is to talk to an experienced estate planning attorney about the matter.