The U.S. Supreme Court recently held in the case of Clark v. Rameker that inherited IRAs are not exempt from such IRA beneficiary’s creditors because inherited IRAs are not considered to be retirement funds. Therefore, creditors of an IRA beneficiary’s inherited IRA can successfully attack the assets inside the inherited IRA.
The question as to whether an inherited IRA was protected from the creditors of such IRA’s beneficiary was not clear before the Clark case. Several states extended protection to such inherited IRAs and several states allowed the creditors of such inherited IRA’s beneficiaries access to the assets held in such inherited IRAs. The Clark case makes it clear that unless the inherited IRA beneficiary lives in one of the very few states that specifically provide creditor protection to inherited IRAs, then the creditors of such beneficiary can access the assets held in such inherited IRA unless additional planning is done. IRAs (both traditional and Roth) offer certain tax advantages to encourage people to save for retirement. Along with these tax advantages, both traditional and Roth IRAs are generally exempt from the creditors of the owners of such IRAs so that their retirement funds will be available for their retirement purposes and they don’t have to worry about creditors undoing their retirement by seizing their retirement funds. The Supreme Court found that these inherited IRAs do not contain the same protected retirement funds since the beneficiaries of inherited IRAs had not contributed funds to the IRAs for retirement purposes as the owners of the IRAs had.
A traditional IRA or Roth IRA created and funded during the lifetime of the owner of such IRA is therefore generally exempt from the creditors of such owner. However, when such owner passes such IRA at death to the designated beneficiary (an inherited IRA), such inherited IRA is not protected against the creditors of the beneficiary of such IRA unless such beneficiary lives in one of the states where inherited IRAs are specifically exempt from creditors or additional planning is done.
Unfortunately, the Court did not clarify if there was any protection available if the beneficiary of the inherited IRA is a surviving spouse of the owner of the IRA. Unlike other beneficiaries, a surviving spouse who is the beneficiary of an inherited IRA has the option to either rollover that IRA into an IRA that such surviving spouse owns, or such surviving spouse can continue as the beneficiary of the inherited IRA. It is not clear from the Clark case whether either of these options surviving spouses have with respect to inherited IRAs will provide any creditor protection. However, not doing a rollover to the surviving spouse’s own IRA is more in line with the facts of Clark and likely is a less attractive option than the rollover option.
To create creditor protection and avoid the results of the Clark case, IRA owners can name trusts as the beneficiaries of their inherited IRAs as opposed to individuals. By naming trusts as beneficiaries, the inherited IRA assets are protected as long as such assets either remain in the inherited IRAs or are held in trust. Once an inherited IRA’s assets are distributed outright to the individual beneficiary of the trust, then the creditors of such beneficiary can potentially seize such assets. For this reason, it is important to consider creating trusts that allow for the accumulation of inherited IRA assets to enhance the creditor protection.
Naming trusts as beneficiaries of inherited IRAs can also help in maintaining the tax-free compounding of the investments held in the IRAs so that the beneficiaries of the trusts have substantially more funds available to provide for their own retirement needs. Generally, any IRA owner with an IRA of $150,000 or more in value should consider naming a trust as beneficiary to enhance the creditor protection against divorce, lawsuits, bankruptcy and other similar negative events.
Alaska, Arizona, Florida, Missouri, North Carolina, Ohio and Texas all have state laws that expressly exempt inherited IRAs from the creditors of such IRA beneficiaries. However, such beneficiary must continually be living in one of the above states in order to receive such protection. Alabama has no specific exemption for inherited IRAs.