How Can I Protect an Inherited IRA from Creditors?

If you’re like most Americans, one of your largest assets is your Individual Retirement Account (“IRA”). Your IRA is considered a “retirement fund” and the money it contains is  protected from creditors who seek to recover debts in bankruptcy.

An owner of an IRA can pass it down to a beneficiary when he or she dies by making a proper beneficiary designation. If the beneficiary is a surviving spouse, the IRA can be rolled over into the surviving spouse’s IRA and can remain protected. But what happens if the spouse doesn’t roll the assets into his or her own IRA, or if someone other than a spouse inherits the IRA? Is an inherited IRA also protected from creditors in bankruptcy?

Are Inherited IRAs Protected in Bankruptcy?

That is a question the Supreme Court recently considered in Clark vs. Rameker.

In that case, Heidi Heffron-Clark was the beneficiary of the IRA that she inherited when her mother died. Rather than cash out the IRA, she decided to take monthly distributions from it. In 2010, nine years after she inherited the IRA, she filed for bankruptcy. She claimed that the inherited IRA contained “retirement funds” and was therefore an exempt asset that was unavailable to creditors.

The United States Supreme Court decided otherwise. In a rare unanimous decision, the Supreme Court held that inherited IRAs are not “retirement funds” for purposes of federal bankruptcy law and are therefore not protected from creditors. The Court reasoned that in contrast to traditional IRAs, those who inherit IRAs cannot contribute additional funds to the account, must take annual withdrawals from the account regardless of their age, and can withdraw the balance of the account without any early withdrawal penalties.

What are the Implication of Clark v. Remeker for Texans?

Some states have passed laws that protect inherited IRAs. In Texas, Section 42.0021 of the Texas Property Code specifically provides that “inherited individual retirement account” are exempt from creditor’s claims. Therefore, it appears that Texas state exemptions would protect an Inherited IRA in a bankruptcy, although the Supreme Court’s opinion did not specifically address state exemption statutes.

It is important to note, however, that it is necessary to have lived in Texas for two years prior to filing for bankruptcy to take advantage of the state’s exemption. Since it’s difficult to predict where your beneficiaries will reside, you may not be able to rely on this exemption to protect an IRA you pass down to your beneficiaries.

How Can an Inherited IRA be Protected from Creditors?

An inherited IRA can be protected from your beneficiaries’ creditors by creating a retirement benefits trust for their benefit rather than making an outright bequest of an IRA. The IRA owner can then identify the trust as the beneficiary of the IRA. Assets in the trust will be protected from creditors, lawsuits, disgruntled soon-to-be ex-spouses, or others who may prey on the beneficiary.

There are many rules that govern the establishment of retirement benefits trust. Anyone planning to take advantage of this type of trust should consult an attorney to ensure that it is properly drafted to accomplish their estate planning goals and objectives.