The Supreme Court ruled on June 12, 2014, that inherited individual retirement accounts (IRAs) are not protected from creditors during bankruptcy proceedings as they are not “retirement funds” within the meaning of 11 U.S.C. §522(b)(3)(c). The petitioners in the case originally filed for bankruptcy under Chapter 7 of the Bankruptcy Code (the “Code”) and attempted to exclude about $300,000 of an inherited IRA from the bankruptcy estate. They claimed that they fit within the “retirement funds” exemption of the Code. The Bankruptcy Court disallowed the exemption but the District Court reversed, stating that the retirement funds exemption covers any account in which funds were saved for retirement. The Seventh Circuit reversed the District Court and the Supreme Court affirmed.
Inherited IRAs are Exposed in Bankruptcy
The Supreme Court pointed out that inherited IRAs differ from traditional IRAs in three significant ways. First, an individual who inherits the IRA is not a contributor and can never invest more money into an inherited IRA. Traditional and Roth IRAs provide tax incentives for investors and are thus quintessential “retirement funds” but inherited IRAs do not provide such tax incentives as there are no income tax deductions for further additions to an inherited IRA.
Second, persons who hold inherited IRAs must withdraw money from the accounts without regard to how far away retirement age is for them. The Tax Code requires an inherited IRA holder to either withdraw the entire account within 5 years after the year of the owner’s death or to withdraw the required minimum distributions each year. In this case, petitioners were taking yearly distributions from the inherited IRA and the account was decreasing in value because of the tax rules governing inherited IRAs without regard to their nearness to retirement. These rules are inconsistent with what one would expect from a retirement fund.
Finally, the holder of an inherited IRA may withdraw any amount from the IRA, at any time, even to the exhaustion of the fund, without penalty. On the contrary, “retirement funds” do not generally allow the original account holder to withdraw money without penalty before age 59 ½. The Court commented that an inherited IRA is a pot of money that can be used freely for current consumption rather than funds set aside for retirement.
The Supreme Court determined that “reference [in the Bankruptcy Code] to ‘retirement funds’ is therefore properly understood to mean sums of money set aside for the day an individual stops working”. This definition makes clear that protection from creditors in the bankruptcy setting is only available to those IRA owners who are the contributors of the funds, not those IRA owners who inherited them because of the death of an IRA owner.
The Estate Planning Solution
What does this mean in the estate planning setting? Is there any way that an owner of a traditional or Roth IRA can benefit a child and protect the funds in the IRA (which upon the owner’s death will be an inherited IRA) from the child’s creditors? Yes!
To gain this creditor protection for the IRA funds, the owner may create a trust and designate the trustee of that trust as the beneficiary of the IRA. The trust would be set up as a discretionary trust, for the benefit of the owner’s child. These simple steps result in the funds in the IRA gaining protection from the child’s creditors even if the child files for bankruptcy.
In simple terms, a discretionary trust is a trust in which the trustee has the power to determine whether to distribute income or principal or both to or for the benefit of the child, including the amount to distribute and when to make the distribution. As a beneficiary of the discretionary trust, the child would not own the assets of the trust (the inherited IRA) and cannot compel distributions; these features insulate the trust assets from the child’s creditors, even in bankruptcy. Once distributions are made to the child, however, those funds are available to the child’s creditors.
There are a variety of trusts that can receive distributions from IRAs. Two common IRA trusts are conduit trusts and accumulation trusts; each trust has income tax issues that must be carefully considered in the planning stages. A conduit trust typically receives IRA distributions and its trustee passes out the required minimum distributions to the trust beneficiaries. An accumulation trust accumulates the RMDs and its trustee may, but typically is not required to, make distributions to the trust beneficiaries.
In most situations, an accumulation trust would provide the best creditor protection for the trust beneficiaries, since the trustee would not have to make any distributions to the trust beneficiaries. The trustee of an accumulation trust could, however, benefit the trust beneficiary in many ways. For example, the trustee could purchase a home for the beneficiary’s use. Such home, being owned by the trustee and not the beneficiary, would not be subject to the enforcement of a judgment obtained by the beneficiary’s creditors.
The Supreme Court’s holding in Clark v. Rameker makes the use of trusts more important than ever to protect inherited IRAs from creditors of intended IRA beneficiaries. The use of IRA trusts can protect and control IRAs after the death of the IRA owner; however, to gain that protection, it is important to select an experienced estate planning attorney to fulfill the Tax Code’s and Trust Code’s very specific requirements for the terms of the trust.
If you want to learn more about how trusts can protect your IRAs from your beneficiaries’ creditors, contact Fraser Trebilcock Trusts and Estates department chair, Marlaine C. Teahan, at 517.377.0869 or firstname.lastname@example.org.
Clark v. Rameker, 134 S.Ct. 2242, 573 U.S. ___ (June 12, 2014).
 Clark, 134 S. Ct., at 2247-2248.
 26 U.S.C. 219(d)(4).
 §§408(a)(6), 401(a)(9)(B).
 Clark, 134 S. Ct., at 2246.
 MCL 700.7103(d).
 MCL 700.7505.