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In a landmark, unanimous decision handed down on June 12, 2014, the United States Supreme Court’s Clark v. Rameker decision held that inherited IRAs (IRAs which are inherited by your children) are not classified as “retirement funds” and can be reached by the creditors of your children when they inherit your IRA.   Thus, the IRA assets which you intended to provide a safe haven for your children can be taken from your children in bankruptcy.  The ramifications of this decision almost certainly extend beyond bankruptcy.  There is a solution!

This ruling is important to you and your family because it means you need to take action to insure your retirement funds are protected when they pass to the next generation – and, perhaps, even to your spouse.  

Here’s what happened in the Clark case:

Ruth Heffron created an IRA, naming her daughter, Heidi Heffron-Clark, as beneficiary. After Ruth died, her IRA assets (approximately $300,000) became an  “Inherited IRA” for her daughter, Heidi. 

Some nine years later, Heidi and her husband, Brandon, filed bankruptcy and sought to protect the Inherited IRA from their creditors. The couple argued the inherited IRA assets were protected retirement funds. Both the bankruptcy trustee and the judgment creditors objected.

The case went all the way to the Supreme Court, which ruled that funds held within an inherited IRA are not “retirement funds.” And, as a result, those funds have no creditor protection as retirement funds and can be seized to pay off debt.  

The Court reached its conclusion using three elements, which differentiate an inherited IRA from a participant-owned IRA:

1.      The beneficiary of an inherited IRA cannot make additional contributions to the account, while an IRA owner can.

2.      The beneficiary of an inherited IRA must take required minimum distributions from the account regardless of how far away the beneficiary is from actually retiring, while an IRA owner can defer distributions at least until age 70 ½.

3.      The beneficiary of an inherited IRA can withdraw all of the funds at any time and for any purpose without a penalty, while an IRA owner must generally wait until age 59 1/2 to take penalty-free distributions.

This simple analysis has sent shock waves through the estate planning and financial advisory worlds. The logic is easily extended to all inherited defined contribution retirement plan accounts, so inherited 401(k) and 403(b) accounts are also affected.

What Can Be Done to Protect Inherited IRAs from Divorce & Creditors?

In light of the Clark decision, clients must thoughtfully reconsider any outright beneficiary designations. By far the best option for protecting an inherited IRA is to create an IRA Beneficiary Trust and have the IRA assets go to that trust with the beneficiary having access to those assets via the trust. If properly drafted, this trust offers the following advantages:

1.         Protects the inherited IRA from beneficiaries’ creditors, divorce, as well as predators and lawsuits
2.         Insures that the inherited IRA remains in the family bloodline and out of the hands of a beneficiary’s spouse, or soon-to-be ex-spouse
3.         Allows for experienced investment management and oversight of the IRA assets by a professional trustee
4.         Prevents the beneficiary from blowing it all on exotic vacations, expensive jewelry, designer shoes, and fast cars
5.         Enables proper planning for a special needs beneficiary
6.         Permits minor beneficiaries such as grandchildren to be immediate beneficiaries of the inherited IRA without the need for a court-supervised guardianship

Could State Law Still Protect Inherited IRAs?

A handful of states, including Arizona, have either passed laws or had favorable court decisions that specifically protect inherited IRAs under state bankruptcy statutes – don’t get too comfortable because this offers little comfort.  However, most states do not offer any protections and if the beneficiary moves to one of these states they could be in jeopardy.  The Best Solution — if their IRA inherited assets are in an IRA Beneficiary Trust they can receive the needed protection regardless of which state they live in.

Caution:  Caution should be used in relying on state law to protect a beneficiary’s inherited IRA. In general, people are more mobile than ever and your beneficiary may need to move from state to state to find work, pursue educational goals, or be closer to family members.  In addition, federal bankruptcy laws now require a debtor to reside in a state for at least 730 days to use state bankruptcy exemptions. Therefore, long-term planning should not rely on a specific state law but instead should consider an IRA Beneficiary Trust.

The Bottom Line

If you have retirement funds, call our office now. We will show you how to protect your assets from your beneficiaries’ bankruptcy creditors, divorcing spouses, frivolous lawsuits, medical crises, additions, and bad decisions. It’s imperative that you take action now because the IRA Beneficiary Trust can only be created by you while you have full capacity. I have created several hundred IRA Beneficiary Trusts since they were approved in 2005.  I will be happy to provide you and/or your client a free consultation.  As always, you as your client’s financial advisor. are welcome to any consultation (with your client’s approval).  Call me at 480-296-2069 or 800-679-6709 to set an appointment.