Individual Retirement Accounts (IRAs) have historically been protected from creditors seeking to access them in cases of bankruptcy. While this is still the case for many IRA’s, a recent unanimous Supreme Court decision has drawn a distinction between types of IRA’s – making it increasingly important that you follow specific steps to protect your retirement assets.
Those who have established and funded their own IRAs are not affected by this decision – in fact, the 2005 Bankruptcy Abuse Protection and Consumer Protection Act improved bankruptcy protection in those cases.
In Clark v. Rameker, the Court drew a distinction between inherited IRAs and those that were created by the holders. The argument hinged on distinct differences with inherited IRAs that make them fundamentally different from straightforward retirement programs.
If you are a non-spousal beneficiary of an IRA, generally you must remove the entire balance of the account within five years, or take out an annual minimum balance based on your life expectancy. For the second option, you must start distributions by the end of the year after the death of the IRA owner, regardless of your age.
Because of these requirements, the typical age-based penalties for early withdrawal do not apply to inherited IRAs – making them fundamentally different from the traditional retirement-based IRA. They are more like an inherited asset that must be converted into a retirement vehicle. With the court’s ruling, failure to take that conversion step opens the asset up to potential creditors.
The ruling is extremely important for surviving spouses that inherit IRAs, because they have the unique option of rolling it into their own IRA. In that case, the assets are incorporated smoothly and subject to the typical IRA rules, with a 10% penalty if the survivor draws money before age 59-1/2. The other two spousal options – owner designation and beneficiary designation – appear to be accessible to creditors under this ruling.
For the owner designation, the surviving spouse assumes ownership and takes distributions based on the original owner’s life expectancy from the actuarial tables (as strange as that sounds, since he/she has passed away). The beneficiary designation sets up a separate account in the decedent’s name for your benefit, and the effect of this ruling on that path is unclear.
In any case, the ruling provides greater incentive for a surviving spouse to roll over an IRA, because that is a clear path to protection of assets. For non-spousal inheritance of IRA’s, you will have to open your own IRA using the funds and take the tax hit if you want to protect the funds from creditors.
If you want your IRA to be directed to a non-spouse, you will probably want to make a trust the beneficiary of the IRA instead of an individual – but these areas of law are complex and subject to change even before this ruling, so it is best for you to seek a qualified professional to help you find and execute the best choice for you.
The justice’s arguments are understandable on a common-sense basis as well as a legal basis – but it does open the door to future decisions that hinge more on legal technicalities and less on common sense. By drawing a distinction regarding IRA mechanisms and their intent with respect to retirement, it is always possible that future rule changes for IRAs could expose a greater number of them to creditor access.
You should be able to protect your own nest egg with reasonable precautionary steps – but keep an eye out for future changes.
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