Beneficiaries Beware: Inherited IRA’s are not protected “retirement funds” in a bankruptcy proceeding

Individual Retirement Accounts (IRA) come with many benefits and are often used as an estate planning tool as they are considered a non-probate asset provided that a beneficiary has been designated for the IRA i.e. with a beneficiary designation these assets bypass the estate.  However, the beneficiary that you designate on your IRA does not necessarily inherit all of the benefits that you hold with your IRA. One of these benefits is creditor protection.

In a bankruptcy proceeding, qualified retirement funds are exempt and thus, not considered a part of the bankruptcy estate. The reasoning behind this exemption is “to help the debtor obtain a fresh start”[1]. Both traditional IRA’s and Roth IRA’s offer tax advantages to encourage individuals to save for retirement and as such are exempt as “retirement funds” in a bankruptcy proceeding.

An Inherited IRA, however, “is a traditional IRA or Roth IRA that has been inherited after its owner’s death”[2]. An Inherited IRA does not operate in the same manner as ordinary IRA’s in that it has different payout requirements and withdrawals from an Inherited IRA are not subject to the same penalties that apply to early withdrawals from traditional IRA’s or Roth IRA’s. With this in mind, last year the US Supreme Court in Clark v. Rameker, 134 S.Ct. 2242 (2014) held that funds held in an IRA that the Chapter 7 debtor had inherited from her late mother were not “retirement funds” as that term was used in the bankruptcy exemption statute.  The Court found that an Inherited IRA did not serve the same purpose as ordinary IRA’s in that the debtor had not created the IRA to save for her own retirement and thus, to exempt an Inherited IRA would essentially give a debtor a “free pass” instead of a “fresh start”.

To avoid this pitfall for your beneficiaries, an IRA trust should be considered, which would, among other benefits, extend creditor protection for the Inherited IRA funds.

[1] Rousey v. Jacoway, 544 U.S. 320, 325 (2005)

[2] Clark v. Rameker, 134 S.Ct. 2242, 2245 (2014)