Until Thursday, June 12, 2014, some courts permitted bankruptcy protection for creditors to funds held in an inherited Individual Retirement Account ("IRA"). Other courts determined that an inherited IRA was not a retirement fund within the meaning of Bankruptcy Code Section 522(b)(c) and, therefore; not entitled to protection from creditors. For many of our clients, retirement accounts represent some of their largest assets. IRAs and other retirement accounts also provide great potential for growth, due to the tax deferred nature of these accounts.
On June 12, 2014, the U.S. Supreme Court ruled that inherited IRAs are not entitled to bankruptcy protection. The Supreme Court unanimously determined that an inherited IRA is not to be considered retirement funds within the meaning of the bankruptcy code.
The story really begins in 2003, when income tax rules were established that permitted non-spousal rollovers on IRA's. Prior to 2003, these favorable rules were only available for a surviving spouse. These new rules have a profound effect and provide a great planning opportunity for your family. The opportunity is best described as a "stretch-out" under the old rules. For example, if the husband died and the wife rolled over his retirement account into her IRA, then she died at 77, according to the IRS life expectancy table she has six years left to live; then the kids had six years to take the funds out and pay the tax. Now, if I am 40 and I am the designated beneficiary, I now have 46 years to pay the tax based upon my life expectancy. The additional years of growth that accumulates on a tax deferred basis are almost beyond belief.
For example, a 50 year-old who inherits a $200,000 IRA (or a similar interest in a 401k). If this account is growing at a rate of 6% and if the 50-year-old only withdraws the required minimum distributions over the next 30 years, that account will still have $300,000 in the IRA. The $200,000 IRA is actually worth $1,000,000 to the beneficiary.
In 2006, the Pension Protection Act allowed many 401k companies and corporate retirement accounts to be rolled over to an IRA, even by a non-spouse beneficiary. The IRAs people inherit may actually be the most valuable asset that they receive.
Many people are concerned that the wrong people may end up inheriting the IRA. Naming the individual beneficiaries directly does not provide any protection from creditors or from divorce. These IRA funds are particularly attractive to an ex-husband or ex-wife because they can be received on a tax-deferred basis through a qualified domestic relations order ("QDRO").
What Is the Right Kind of Trust to Optimize IRA Inheritance?
A revocable trust can be drafted to provide a significant asset protection for the children or beneficiaries such as with a Beneficiary Controlled Trust. However, using a basic revocable trust is unlikely to qualifiy for the "stretch-out" income tax deferred due to the deceptively complex requirements for a trust to qualify. This decision is not typically made by the IRS, but is made by the plan administrator and its legal department. This may require the trust to pay the tax in as little as five (5) years. Instead of a "stretch-out" and significant increase in value, this results in a "blow out" where 1/3 to even 2/3 of the potential increase in value is lost.
An IRA Inheritance Trust© can help preserve the stretch-out or increase in value and provide significant asset protection for the beneficiaries. An IRA Inheritance Trust© is particularly effective to protect beneficiaries for any of the following issues:
- Wrong people eventually inheriting your IRA - such as from later marriage
- Poor spending habits of beneficiaries, their spouses and children
- Poor money management skills of beneficiaries
- A beneficiary's spouse taking some in a divorce
- A young, elderly, or disabled beneficiary who is unable to properly manager his affairs
- A beneficiary losing his government benefits
- Lawsuits, creditors, or even bankruptcy grabbing the IRA!
- Estate taxes when they pass it down to their children
Naming individuals as beneficiaries provides no protection against these! Particularly after the Supreme Court decision in Clark v. Raemaker on June 12, 2014.