On June 12, 2014, the Supreme Court unexpectedly provided yet one more reason why you should designate a trust as beneficiary of your IRA rather than simply designating one or more individuals as beneficiaries.
In a unanimous opinion affirming a decision of the 7th Circuit, the Court in Clark v. Rameker ruled funds held in an inherited IRA are not protected from creditors in bankruptcy.
In 2001, Heidi Heffron-Clark inherited an IRA from her mother with a date of death value of $450,000. She began taking the required minimum distributions from the account, calculated with reference to her life expectancy. So far, so good.
By 2010, the IRA was down to $300,000. Ms. Heffron-Clark and her husband ran into money troubles and filed for bankruptcy under Chapter 7. They claimed the inherited IRA was a "retirement account" under the bankruptcy law and thus exempt from creditor claims.
The bankruptcy court disagreed, but the district court reversed. But then the appeals court reversed the district court. Back and forth. The Clarks took the matter to the Supreme Court, citing a conflict among the federal appeals courts on the issue.
Writing for a unanimous Court, Justice Sotomayor said there were three reasons an inherited IRA is not a "retirement account" exempt from creditor claims in bankruptcy. First, the holder of an inherited IRA may not put more money in the account, as she might with her own IRA. Second, she is required to start withdrawing funds shortly after the death of the original IRA owner, regardless how many years she might be from retirement herself.
Third, the holder of an inherited IRA might withdraw the entire account, for any purpose, without incurring the ten percent penalty she would incur if she took money out of her own IRA before reaching age 59-1/2. And she might do this the day after the bankruptcy proceeding closed.
Even before the Clark ruling, the first concern for most IRA owners in planning to leave an undistributed balance to a child or other beneficiary has always been how to protect the fund from being depleted by a spendthrift, or exposed to the claims of creditors or divorced spouses.
Under the required minimum distribution (RMD) rules, an inherited IRA may be "stretched out" over the life expectancy of the beneficiary. This almost always results in the lowest income taxes and the highest total value to the beneficiary. However, if the account is left outright rather than in trust, the beneficiary can take out as much as she wants immediately, without waiting for the minimum distributions. She would incur a substantial income tax, possibly at higher marginal rates, and she would lose the benefit of tax-deferred compounding, but she could do it.
After the Clark ruling, we now have the additional concern that the beneficiary's creditors may reach the inherited IRA -- in a joint bankruptcy, such as the Clarks, the creditors of either spouse.
To state it more bluntly: before Clark you had to worry that your daughter might withdraw your entire IRA to fund her boyfriend's brewpub, or that your son might need to use your IRA to buy an "emergency" Corvette. Now you have to worry not only about those scenarios, but also that your IRA might end up paying for debts incurred by your son-in-law or daughter-in-law, even if your own child was sensible enough not to invade the account.
A competent planning lawyer knows how to anticipate these risks and to plan to protect you and your family from them. Contact us today for more information.