When an IRA account owner dies, his or her designated beneficiary can choose to withdraw the account or maintain the IRA as an “Inherited IRA.” Numerous beneficiaries of Inherited IRAs have declared bankruptcy and claimed that the Inherited IRA was exempt from attachment by the creditors. Some Circuit Courts of Appeal had held that inherited IRAs are exempt funds in a bankruptcy setting. Other Circuits had ruled to the contrary.
The Supreme Court has resolved the conflict by ruling that inherited IRAs are not exempt for bankruptcy purposes. The court’s rationale was that the purpose of the bankruptcy exemption for retirement funds is to protect the money for the person who earned the money. The exemption was not meant to protect heirs of the person who earned the money.
Some states have exempted Inherited IRAs from bankruptcy. Depending on where the beneficiary of the Inherited IRA lives, he or she may be able to use the state exemption and not be affected by the Supreme Court ruling.
The practical effect of the ruling for debtors living in the wrong states is to make Inherited IRAs the same as any other account owned in the debtor’s name. The account will not be protected if the debtor declares bankruptcy.
In light of this ruling, surviving spouses should consider segregating an IRA that they inherit from their spouse in a separate account. The law allows you to combine your spouse’s IRA with your own IRA; however, that may bring into question the creditor protection benefits of your own IRA. Further, if you maintain separate accounts, you should make withdrawals from the Inherited IRA rather than your own IRA.
When designating the beneficiary of your own IRA, you should consider establishing a trust as the beneficiary. A properly drafted trust will give your beneficiary the flexibility to withdraw the funds over several years without exposing the funds to the beneficiary’s creditors.
Despite the Supreme Court’s ruling, you can still achieve creditor protection for the portion of your IRA that you pass on to your beneficiaries. However, the process to obtain the creditor protection has become more complicated.