In general, under the 2005 Bankruptcy Code, IRAs and other retirement accounts, such as 401(k)s and SEP plans, are protected in the event of bankruptcy by the owner—which is one more reason to fund your retirement plan with as much as possible. But what about an inherited IRA? The U.S. Supreme Court decided in the 2014 case, Clark v. Rameker, that these types of retirement accounts do not enjoy any bankruptcy protection.
A Short Refresher on IRAs
Inherited IRAs have many similarities to and differences from traditional retirement plans. Most retirement plans are created by the worker setting aside a portion of her income each year into a retirement account. Often the employer contributes as well. The contributions of both the employee and employer are not taxed when the contributions are made, nor are earnings on the funds, such as dividends, interest and capital gains, taxed. However, withdrawals from the retirement plans are taxed when taken. Further, since the purpose of these accounts is to set aside money for retirement, withdrawals made before age 59 1/2 (with exceptions for disability) are also subject to a 10% excise tax or penalty. After age 70 1/2, taxpayers must take minimum distributions each year starting at 3.65% or face a similar excise tax on the un-taken distribution.
And Inherited IRAs
Inherited IRAs come into existence when the owner of a retirement plan passes away and the funds pass to a named beneficiary. Unlike their own retirement plan, from which they can delay withdrawals until age 70 1/2, owners of inherited IRAs must begin withdrawals the year following the death of the prior owner. However, since the minimum distributions are set according to age, their required withdrawals can be relatively small. For instance, a 50-year-old owner of an inherited IRA is required to withdraw a minimum of 2.9% of the IRA’s value. The tables for inherited IRAs are more accelerated than for retirement plans owned by the original worker. For instance, if, at age 70 1/2, a taxpayer must withdraw at least 3.65% or his own retirement plan, at the same age he’s required to take out at least 5.9% of his inherited IRA.
There are two instances in which these rules do not apply. First, surviving spouses inheriting retirement plans may roll them over into their own IRAs, to which the same rules apply as retirement plans that they fund themselves. Second, if the retirement plan does not have a designated beneficiary, it must be withdrawn within five years after the owner’s death. This can occur because there is no named beneficiary, the beneficiary died before the owner and the owner never updated her plan, or a trust was named and it does not meet the specific requirements to qualify as a designated beneficiary to a retirement plan. The result can be higher taxes if the accelerated withdrawals push the recipient into a higher tax bracket or simply the loss of the benefits of deferred taxation.
While every financial planner and estate planning attorney will advise their clients to take the necessary steps to permit their beneficiaries to “stretch” the IRAs and defer taxation as long as possible, our experience is that many people who inherit retirement plans simply “take the money and run.” In other words, while the five-year withdrawal requirement on retirement plans without designated beneficiaries would seem to cause a serious tax penalty for heirs, in fact even when they can stretch their IRAs, we find that many beneficiaries do not take advantage of this opportunity.
Using Family Protection Trusts for the “Stretch” and Creditor Protection
One way to make sure that beneficiaries take full advantage of the tax deferral opportunity the inherited IRA offers is to leave funds in trust for beneficiaries rather than transferring them outright to them. This also provides creditor protection that the Supreme Court in Clark v. Rameker deemed unavailable to owners of inherited IRAs. We call these “family protection trusts” because they protect the family from creditors and in the event of divorce, as well as keeping funds in the family if a child passes away at a relatively young age. Beneficiaries may be discouraged from withdrawing IRAs in a family protection trust if they understand that in addition to the tax benefits, they will be giving up the creditor and family protection features offered by the trust.
Here are some articles about family protection trusts:
Margolis & Bloom, LLP, practices estate, long-term care and special needs planning in Boston, Norwood, and Wellesley with a strong commitment to client service. If you have questions about these or other legal matters, do not hesitate to contact us by calling 781-705-6400.