Individual Retirement Accounts (often referred to as “IRAs”) have become a popular and common tool for planning for retirement. Upon the death of the owner of an IRA, any assets remaining in the IRA will pass, pursuant to a beneficiary designation, either to the owner's surviving spouse, or to the owner’s estate or one or more other beneficiaries in the form of an "inherited IRA." For this reason, IRAs must be considered in developing an estate plan. However, IRAs should also be considered in asset protection planning. The law is fairly well settled that an IRA is protected from most creditors of the initial contributor of the IRA. However, it remains unclear whether inherited IRAs receive the same protection with respect to the creditors of the IRA beneficiary. Two recent bankruptcy court cases, In re Nessa and In re Tabor, have held that inherited IRAs are afforded the same protection from the creditors of the beneficiary of the inherited IRA as would have been afforded the initial owner of the IRA prior to his or her death.
The extent to which these cases will impact the law in this area (which has previously held that inherited IRAs were not protected) remains unclear, so it is important to consider strategies to protect such inherited IRAs.
IRAs and Inherited IRAs
A traditional IRA (which differs from a Roth IRA, the tax treatment of which is not discussed here) is a trust or custodial account created for the benefit of an individual and/or his beneficiaries which meets certain requirements set forth in the Internal Revenue Code. Subject to certain limitations, contributions to a traditional IRA are generally deductible, up to a certain amount each year, and the income and gains within a traditional IRA are generally not taxed until distributed. The owner of an IRA must begin taking distributions from the IRA by a certain age, and will be penalized for taking distributions from the IRA before a certain age. Once the owner of an IRA dies, the designated beneficiaries of the IRA (other than the surviving spouse of the initial owner) receive the assets in the IRA in the form of an inherited IRA and must withdraw the entire amount of the IRA account by the end of the fifth year following the initial owner’s death, or begin taking distributions from the IRA account based on the oldest beneficiary’s life expectancy. The beneficiary of an inherited IRA cannot make additional contributions to the IRA, and different tax rules apply to inherited IRAs than apply to IRAs in the hands of their initial owners. An IRA of which the owner's surviving spouse is the designated beneficiary may be rolled over into his or her own IRA and will likely remain protected from the spouse’s creditors.
Creditor Protection of IRAs and Inherited IRAs
There is little doubt that an IRA is generally protected from most creditors of its initial contributor (one exception is the IRS). Federal bankruptcy law specifically exempts IRAs from the bankruptcy estate of their owners (with a $1 million limitation for traditional IRAs). However, federal law does not provide such explicit protection for inherited IRAs. Additionally, some debtors in bankruptcy may be required to use the exemptions provided by state law, rather than the federal exemptions. With one exception, courts which have considered whether inherited IRAs are protected from the creditors of their beneficiaries in bankruptcy under state law exemptions have held that inherited IRAs do not receive such protection.
Recently, courts have decided the issue of whether inherited IRAs are protected from the claims of creditors under the exemption provided by federal bankruptcy law, rather than state law. In In re Chilton, decided in March of this year, the Bankruptcy Court for the Eastern District of Texas held that an inherited IRA is not protected from the claims of creditors under federal bankruptcy law because the inherited IRA was not created to provide for the beneficiary's retirement, and the beneficiary would be able to withdraw funds from the inherited IRA regardless of the beneficiary's age or retirement status without penalty. However, shortly after Chilton was decided, the Eighth Circuit reached the opposite conclusion in Nessa, holding that an inherited IRA still contained "retirement funds" within the meaning of federal bankruptcy law, even though they were not the debtor's own retirement funds. Shortly thereafter, the Bankruptcy Court for the Middle District of Pennsylvania, in Tabor, agreed with the decision in Nessa and again concluded that the exemptions provided by federal bankruptcy law protect "retirement funds" without specifying that they must be the debtor's retirement funds.
Although these recent cases may indicate that the tide has turned with respect to providing creditor protection to inherited IRAs, it is too soon to know whether, and to what extent, other courts will follow these recent decisions. As the majority of the authority on this issue indicates that inherited IRAs are not protected from the claims of the beneficiary's creditors, it is not yet safe to assume that all inherited IRAs will receive such protection.
Planning to Protect Inherited IRAs
As it is at least unclear whether an inherited IRA will be protected from the claims of the beneficiary's creditors, it is important to consider asset protection planning in order to provide such creditor protection. One way of providing such protection is by designating a trust as the beneficiary of an IRA upon the death of the initial owner. A trust which is designated as the beneficiary of an IRA, and which includes certain provisions prohibiting the assignment or transfer of the beneficiaries' interests in such trust, can provide significant protection of the funds held in an inherited IRA until such funds are distributed to the beneficiaries. Such a trust may be created inter vivos (during life), or under the initial IRA owner's will.
The trust may be drafted so that the trustee has complete discretion in determining whether to make distributions to the beneficiaries and in what amount. The trustee would also have the discretion to accumulate the distributions from the inherited IRA within the trust, providing greater protection from creditors, and preserving such funds for future generations. Alternatively, the trust could be drafted as a "conduit trust." A conduit trust is a trust which, as its name suggests, acts as a conduit for the distributions from the inherited IRA, by receiving the minimum required distributions from the inherited IRA, and paying them out to the beneficiary of the trust. A conduit trust will not provide as much protection from the claims of the beneficiary's creditors as a trust in which the trustee's ability to make distributions is completely discretionary. The trustee will be required to make distributions from the conduit trust and, once the distributions are made, the distributed amount is subject to the claims of the beneficiary's creditors. However, conduit trusts can provide certain tax advantages over purely discretionary trusts. The advantages and disadvantages of each type of trust should be considered, and the type of trust which works best for any individual will depend on the particular needs and objectives of the individual and his or her family.