An Individual Retirement Account (IRA) that is inherited by a designated death beneficiary will not be treated as a retirement account exempt from the beneficiary”s creditors inside a bankruptcy. So decided the US Supreme Court on June 12 in Clark et ux v. Rameker. Let us review the benefits of retirement accounts and what can be done to protect IRA assets against creditors of a death beneficiary given the Clark decision.
IRA”s are tax shelters that allow for tax-free growth of one”s contributions from earnings. One may not withdraw money from a retirement account prior to age 59 ? without paying a 10-percent penalty such early withdrawals. After age 70 ?, one must take required minimum distributions annually over one”s life expectancy, or in special cases, over the joint and several life expectancies of the participant and his or her spouse. All distributions from any retirement account are taxed to the recipient as ordinary income in the tax year received.
A designated death beneficiary, after inheriting the IRA, must take required minimum distributions over the course of their own life expectancy, under the Internal Revenue Service”s (IRS) life expectancy tables, beginning in the year after inheritance.
In addition to sheltering contributed earnings from income taxes, retirement accounts are excellent ways to protect retirement assets from judgment creditors.
Inside a bankruptcy, up to $1.2 million in employee contributed IRA money, including any rollovers inherited from a deceased spouse, is protected from creditors. Even better protected are employer sponsored retirement plans, most notably 401(k)”s and pensions. These have unlimited protection inside bankruptcy.
Outside a bankruptcy, employer retirement plans that qualify under Federal Employee Retirement Income Security Act (ERISA) law still enjoy absolute and unlimited protection. The same is true for non-ERISA employer sponsored “private retirement plans” under California law.
Protection given to IRA”s, however, is not absolute, is limited and varies from state to state. California protects IRA”s to the extent the owner demonstrates that he or she will need the IRA to remain off of welfare in retirement.
So, given the Clark decision, can an inherited IRA be protected against the beneficiary”s creditors? Yes, if the IRA is not inherited outright by the death beneficiary, but distributions from the IRA go into a discretionary spendthrift trust for the benefit of such person(s).
A spendthrift trust allows the trustee to deny creditor claims of the beneficiaries while holding the assets for the benefit of the beneficiary. Rather than making outright distributions to the beneficiary, which might then be taken by creditors, the trustee of a discretionary spendthrift trust has authority to pay living expenses and to make purchases of goods and services on behalf of the beneficiary.
Whether, how, and how much to distribute is all left to the discretion of the trustee. Otherwise, if the beneficiary had mandatory rights to receive trust distribution, the beneficiary”s own creditors could step into the shoes of beneficiary and exercise these rights to require the trustee to distribute assets. Assets in the hands of the beneficiary are more susceptible to being taken by the creditors.
Lastly, and importantly, any trust that receives distributions from retirement accounts, including IRA”s, must be carefully drafted to preserve the tax deferral of IRA distributions into the trust, over the lifetime of the trust beneficiary. Any alternative beneficiary, should the primary beneficiary die, should be someone who is younger than the primary beneficiary. Otherwise, the older alternative beneficiary”s shorter life expectancy becomes the measuring life for required minimum distributions.
Dennis A. Fordham, attorney, is a State Bar-certified specialist in estate planning, probate and trust law. His office is at 870 S. Main St. in Lakeport. He can be reached by email at dennis@dennisfordhamlaw.com or call 263-3235.
