Inherited IRA’s are not Protected Retirement Plans

An
Individual Retirement Account (“IRA”) that is inherited by a designated death
beneficiary will not be treated as a retirement account exempt from the
beneficiary’s creditors inside a bankruptcy.
So decided the US Supreme Court on June 12, 2014, in Clark et ux v.
Rameker.  Let us review the benefits of
retirement accounts and what can be done to protect IRA assets against
creditors of a death beneficiary given the Clark decision.

IRA’s are tax shelters that allow for tax free
growth of one’s contributions from earnings. One may not withdraw money from a
retirement account prior to age 59 ½ without paying a ten percent penalty such
early withdrawals.  After age 70 ½, one
must take required minimum distributions annually over one’s life expectancy,
or in special cases, over the joint and several life expectancies of the
participant and his or her spouse.  All
distributions from any retirement account are taxed to the recipient as
ordinary income in the tax year received.

A designated death beneficiary, after inheriting the
IRA, must take required minimum distributions over the course of their own life
expectancy, under the Internal Revenue Service’s (“IRS”) life expectancy
tables, beginning in the year after inheritance.

In addition to sheltering contributed earnings from
income taxes, retirement accounts are excellent ways to protect retirement
assets from judgment creditors. 

Inside a bankruptcy, up to $1.2 million in employee
contributed IRA monies, including any rollovers inherited from a deceased
spouse, are protected from creditors.
Even better protected are employer sponsored retirement plans, most
notably 401(k)’s and pensions.  These
have unlimited protection inside bankruptcy.

            Outside
a bankruptcy, employer retirement plans that qualify under Federal Employee
Retirement Income Security Act (“ERISA”) law still enjoy absolute and unlimited
protection.  The same is true for
non-ERISA employer sponsored “private retirement plans” under California law. 

Protection given to IRA’s, however, it is not
absolute, is limited and varies from state to state.  California protects IRA’s to the extent the
owner demonstrates that he or she will need the IRA to remain off of welfare in
retirement.  

            So,
given the Clark decision, can an inherited IRA be protected against the
beneficiary’s creditors?  Yes, if the IRA
is not inherited outright by the death beneficiary, but distributions from the
IRA go into a discretionary spendthrift trust for the benefit of such
person(s). 

A spendthrift trust allows the Trustee to deny
creditor claims of the beneficiaries while holding the assets for the benefit
of the beneficiary.  Rather than making
outright distributions to the beneficiary, which might then be taken by
creditors, the trustee of a discretionary spendthrift trust has authority to
pay living expenses and to make purchases of goods and services on behalf of
the beneficiary. 

Whether, how, and how much to distribute is all left
to the discretion of the trustee.
Otherwise, if the beneficiary had mandatory rights to receive trust
distribution, the beneficiary’s own creditors could step into the shoes of
beneficiary and exercise these rights to require the trustee to distribute
assets.  Assets in the hands of the
beneficiary are more susceptible to being taken by the creditors.

Lastly, and very importantly, any trust that
receives distributions from retirement accounts, including IRA’s, must be
carefully drafted to preserve the tax deferral of IRA distributions into the
trust, over the lifetime of the trust beneficiary.  Any alternative beneficiary, should the
primary beneficiary die, should be someone who is younger than the primary
beneficiary.  Otherwise, the older
alternative beneficiary’s shorter life expectancy becomes the measuring life
for required minimum distributions.