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Is an Inherited IRA Safe from Creditors?

Supreme Court’s Decision

The Federal Bankruptcy code allows debtors to exempt certain kinds of property from a bankruptcy estate, including retirement accounts such as IRA & Roth IRA accounts. However, a 2014 Supreme Court ruling clarified that in the eyes of the court, inherited IRAs are not retirement accounts at all, because of a few key points:

  • There are no early withdrawal penalties on inherited IRAs.
  • The beneficiaries can not make contributions to the account.
  • Since beneficiaries are required to take minimum withdrawal each year, the court ruled that “the possibility that an account holder can leave an inherited IRA intact until retirement and take only the RMD does not mean an inherited IRA bears the legal characteristics of retirement funds”.

Not All Hopes are Lost

There are still a number of open questions this case did not address such as the situation where a  spouse inherits an IRA from a deceased spouse. It could be argued that these are assets that both spouses intended to use for their retirement and thus should be protected.

Also, one must look at state law as some states expressly exempt inherited IRAs under state bankruptcy statutes.  In California, for example, the Supreme Court decision may not be conclusive. Like most other states, California has opted out of the Federal bankruptcy exemption scheme so California debtors must use state law exemptions. California courts may decide to follow the Supreme Court’s decision in the absence of contrary authority but on the other hand, they may still decide that the state law exemption applies to inherited IRAs.

What are the planning ramifications?

  • Our default strategy has long been to recommend rollovers of 401K plans to IRAs for flexibility and control. However, if you are worried about asset projection, maintaining assets in a ERISA retirement plan such as a 401K plan may be a better option.
  • Consider a Retirement Trust and name it as beneficiary- a trust can be named as beneficiary of an IRA which could provide additional bankruptcy protection. However, having a trust as beneficiary may trigger higher income tax rates, so you need to consult a professional and tread carefully in this area.
  • Have an umbrella insurance policy in place. While this won’t protect you from every situation, it is a relatively inexpensive way to provide substantial amount of protection for one’s assets. To learn more about what an umbrella policy is, click here.