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A Jewel Falls from the Crown of Qualified Retirement Plans– Inherited IRAs are No Longer Immune from Creditor Claims.

Since the mid-1970’s, qualified retirement plans in all forms (profit-sharing, pension, IRA, SEP, 401K, etc.) have been the crown jewels of financial planning: funded with before-tax dollars, compounding rapidly in tax-deferred investments, and protected in bankruptcy from creditors.  What could be better?  A recent Supreme Court decision took one of the jewels from the crown when it found that inherited IRAs are not protected from creditors.

In the approximately 40 years since qualified retirement plans took center stage, their favored status  has been proven by the fact that they now own close to a majority of the publicly traded stocks in the United States, trillions of dollars’ worth.  Available in many forms, they allow earned income to avoid income taxes when first invested in the plan; the plans then grow rapidly because the  earnings  compound annually without income taxes being assessed against the growth; and finally, in the payout years, when income taxes are assessed, tax brackets are typically much lower than the years when the contributions and earnings were accruing.  As if this weren’t enough, such plans are flexible, allowing transfers from one plan to another, or rollovers to an IRA, and permit one spouse to inherit them from another spouse without paying either estate or income taxes.  All of this is significantly enhanced by the fact that such plans are generally immune from the claims of creditors, even when the owners of those funds file bankruptcy.  In recent years, it has become legally possible to inherit IRAs, so that succeeding generations may continue the deferral of income on these growing assets.

Finally, one jewel has fallen from this many-faceted crown of the investment world.  In its decision of June 12, 2014, the United States Supreme Court decided in Clark v. Rameker that inherited IRAs are not exempt from the claims of creditors.  Pointing out the many, significant differences between an inherited IRA and one that has been created by a person’s own earned income, the Supreme Court refused to make such assets immune from creditors’ claims in bankruptcy.  In that case, Ruth Heffron died and left her IRA of $450,000 to her daughter.  Her daughter had drawn it down to about $300,000 when she was compelled by her debt situation to file bankruptcy.  The exemption of inherited IRAs from bankruptcy claims had been a topic of much speculation and contradictory rulings in lower courts.  The daughter argued that the IRA funds should be preserved to her through the bankruptcy because they were retirement funds.  The Bankruptcy Court agreed  with creditors that the funds could be seized; the United States District Court for the Western District of Wisconsin reversed the Bankruptcy Court, and was reversed in turn by the U.S. Court of Appeals for the 7th Circuit, landing the long-pending question before the U.S. Supreme Court.  It is now clear and final that inherited IRA funds are not exempt in bankruptcy from the claims of creditors.

That is not the end of the story.  There remain ways to continue the deferral of income tax on such funds for the benefit of successor generations, after the contributor’s death, while protecting such funds from creditors (see our April 7, 2014 post on Spendthrift Trusts). However, this is a far more complex arrangement than simply naming your heirs as beneficiaries of your IRA, and requires specialized legal assistance and planning.

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