Inherited IRAs don't play by the same rules

When is a retirement fund not a retirement fund? Apparently, when it’s inherited. At least that’s what the U.S. Supreme Court ruled back in June. There was no waffling from them as it was a unanimous, 9-0 decision. Oh, did I mention that this might affect your IRA? Got your interest now?

In the case of Clark V. Rameker, Heidi Heffron-Clark filed for bankruptcy with her husband. The question was whether or not an IRA she owned was up for grabs by her creditors. At first glance it seems that there is no way this is possible. After all, it is clear in federal law that IRAs are protected in the case of bankruptcy (well, a bit over $1.2 million is).

In this case, however, they weren’t dealing with a regular IRA, they were dealing with an inherited IRA. Heidi’s mother had died, and Heidi inherited her mom’s IRA. Clark argued that the law specifically stated that retirement funds were exempt. The creditors disagreed, contending that since the account was for her mom’s retirement, it should no longer be considered a retirement fund once it was inherited (the fact that it is still called an Individual RETIREMENT Account didn’t seem to matter).

The U.S. Supreme Court agreed with the logic.

Now, if you inherit an IRA from someone other than your spouse, good for you—but don’t think that you’ll be able to keep it if you stiff your creditors. If you are a widow and inherit your spouse’s IRA you have the ability to roll that into your own name. This “rollover IRA” will be protected from creditors.

The majority of my readers live in Texas. I’ve got good news for them. Texas, in its infinite wisdom, has in its bankruptcy laws an exemption for inherited IRAs. This supersedes the federal law. So if you go bankrupt in Texas the inherited IRA you own is exempt. Your creditors can’t get their hands on it.

But don’t rest on your laurels. People, after all, move. If your kids are going to inherit your big IRA, remember that those younger folks seem to move a lot.

So what do you do to protect your kids’ inheritance in case they move to or are already in one of the 43 states that do not exempt inherited IRAs under bankruptcy statutes? For this I asked my estate attorney friend, Dan Campbell. Dan told me that a type of trust that protects IRA assets in bankruptcy is the “conduit trust.” This has the additional benefit of protecting against a “spendthrift beneficiary” from cashing out the IRA immediately upon your death and buying that new Ferrari. It can also keep assets in the family in case of a divorce.

With a “conduit trust” the beneficiary is entitled to the minimum required distribution each year, but they can’t withdraw more than the required amount, which is calculated based on the life expectancy of the beneficiary of the trust. So, while you may not anticipate leaving your IRA to someone who is facing bankruptcy, the rules are still worth knowing to protect your future beneficiaries. 

This article was published in the Wichita Falls Times Record News on August 3, 2014.