In the recent United States Supreme Court decision in Clark vs. Rameker, the Court ruled that inherited IRAs are not “retirement” accounts for purposes of the federal bankruptcy protection statutes. This ruling has a significant effect on IRA planning.
As we are all aware, a bankruptcy is the process of liquidating or reorganizing a debtor’s assets in order to satisfy debt. As part of this process, there is also a determination of what assets belonging to the debtor should be protected or exempt from the claims of creditors in order to allow the debtor to maintain a basic standard of living. The code is very favorable to retirement accounts owned and established by the debtor, including IRAs, with an exemption of up to $1 million.
The Supreme Court held in Clark that an IRA inherited by someone other than a surviving spouse, such as the original IRA owner’s child, who then files bankruptcy, is not that person’s “retirement” account for purposes of the bankruptcy exemption, because they do not permit contributions, they have ongoing distribution requirements regardless of age or retirement, and they have no early withdrawal penalties associated with them. It should be noted that some inherited IRAs will be protected by state bankruptcy law, but the state law that applies is the state of residence of the child/debtor and not the state of residence of the deceased IRA owner.
The consensus of bankruptcy experts is that the IRA should be left to a trust with the child as the beneficiary rather than to the child directly, in order to provide bankruptcy protection. Of course, for estate planning purposes, the IRA trust, just like any other trust established by a third-party on behalf of a beneficiary, will provide protection from the beneficiary’s creditors.
However, there are some additional considerations that must be kept in mind when establishing an IRA trust. The primary question is whether the IRA trust will be a conduit trust which passes annual distributions through to the beneficiary without discretion by the trustee, or an accumulation trust. An accumulation trust will provide the most asset protection for the beneficiary because the trustee has absolute discretion to determine the amount and timing of distributions from the trust to the beneficiary. However, the downside to an accumulation trust is that it takes careful drafting to ensure that the trust is considered to be a designated beneficiary under the IRA rules and it can also trap income inside the trust which will be taxed at the higher trust tax rate.
What this all means is that from an estate planning perspective, the biggest implication of the Clark ruling is that, for those persons interested and concerned about asset protection for loved ones, careful consideration must be given to how retirement assets are bequeathed.