Inherited IRAs: Not Safe From Creditors

​Funds in an IRA aren't subject to creditors' claims — it's said they are exempt from inclusion in the bankruptcy estate. This rule is meant to help debtors who go through bankruptcy to get a fresh start. But when an IRA owner dies and the account is inherited and that person files for bankruptcy, does the rule still hold?

The U.S. Supreme Court said several years ago that if the beneficiary isn't the original owner, then no. This decision surprised veteran court watchers. The Court held that after the death of an IRA owner, assets in an inherited IRA for a non-spouse beneficiary no longer constitute retirement funds for bankruptcy purposes — they are not protected from creditors' claims. In the Supreme Court case, the beneficiary was a daughter and her husband.

What does all this mean to you? As an IRA owner, you'll now have to take additional steps to protect your heirs from creditors after you die.

Say you create a spendthrift trust and designate it as beneficiary of your inherited IRA and don't name individual heirs. Your children are the beneficiaries of the trust. The trust includes a spendthrift provision that provides that beneficiaries cannot access the trust principal or promise it to anyone else. Because the beneficiary cannot access trust funds, neither can his/her creditors. All assets in such a trust — including inherited IRA funds — receive legal protection from the beneficiary's creditors after the IRA owner dies.

You have to check whether your state is subject to the Supreme Court's decision. Individual states are allowed to establish their own bankruptcy exemptions that can differ from the federal rules subject to the Supreme Court's decision. In fact, some states have already exempted all inherited IRAs from creditors' bankruptcy claims, and more may move in the same direction.

Now you may be worried that your retirement nest egg may be more vulnerable. See what you can do to get your state to offer the kind of ironclad protection from creditors that's afforded pension benefits and 401(k) plans. You of course don't want your heirs to lose some or all of your retirement money if they're sued or file for bankruptcy.

Attorneys who are experts in creditor protection offer these ideas:

• Boost insurance coverage —Liability insurance can help protect you from a disastrous lawsuit. If you have significant retirement assets, you may need to consider an umbrella liability policy that can provide supplemental coverage up to $10 million.
• Rethink retirement rollovers —You might consider leaving your 401(k) money in a previous employer's plan or transferring it directly into a new employer's plan rather than rolling the money into an IRA when you change jobs. You need to weigh the quality of your investment choices; you may be better off risking rolling your money into an attractive investment in an IRA than suffering poor returns from inadequate choices in a 401(k).

​Of course, the above solutions may not be right, or even necessary, in every case. What's the right choice for you? Give us a call so we can give you the best advice on retirement fund security for your particular situation.