Recently the U.S. Supreme Court issued a ruling related to whether creditors could reach an inherited IRA. Many individuals assumed that all IRAs were protected from creditors; however, the Supreme Court disagreed under federal bankruptcy law.
The issue arose when an individual, who inherited an IRA from her mother, filed for personal bankruptcy. The individual claimed that because the account was a qualified retirement account (IRA), it was protected under the Bankruptcy as an exempt asset, and therefore, not subject to creditors’ claims.
The Supreme Court ruled that inherited IRAs are not true retirement accounts, and are not entitled to creditor protection. The Court reasoned that there are basic differences of inherited IRAs that caused them to not be retirement accounts. First the beneficiary of an inherited IRA may not add additional funds to the account. Second, the beneficiary of the inherited IRA must make mandatory withdrawals from the account regardless of his or her age. Finally, the funds from the inherited IRA could be withdrawn at any time.
So what can be done to protect an inherited IRA from the creditors of the beneficiary?
If the beneficiary hasn’t declared bankruptcy there may be relief under state law. For example, Massachusetts generally exempts IRAs from attachment by creditors, with several exceptions such as divorce.
If the beneficiary of the inherited IRA is the surviving spouse of the account owner, the surviving spouse should consider rolling over the IRA into his or her own IRA. A spousal rollover makes the account the IRA of the spouse and should differentiate it from an inherited IRA.
If the beneficiary of the IRA will not be the surviving spouse, the owner of the account could name a trust as the beneficiary. Distributions made after the death of the owner would be made to the trust rather than directly to individual beneficiary, which would provide creditor protection for that beneficiary. There are, however, complex rules that must be adhered to when naming a trust as the beneficiary of an IRA in order to minimize the income tax effect.