In a unanimous opinion, the U.S. Supreme Court rules that funds held in an inherited individual retirement account (IRA) are not exempt from creditors in a bankruptcy proceeding because they are not retirement funds. Clark v. Rameker (U.S., No. 13-299, June 13, 2014).
Heidi Heffron-Clark inherited an IRA from her mother. Inherited IRAs must be distributed within five years, and Ms. Heffron-Clark opted to take monthly distributions. During the five-year period, Ms. Heffron-Clark and her husband filed for bankruptcy and claimed that the IRA, worth around $300,000, was exempt from creditors because bankruptcy law protects retirement funds.
The bankruptcy court found that the IRA was not exempt because an inherited IRA does not contain anyone’s retirement funds. Ms. Heffron-Clark appealed, and the district court reversed, ruling that the exemption applies to any account containing funds originally accumulated for retirement. The Seventh Circuit Court of Appeals reversed, holding that the money in the IRA no longer constituted retirement funds, while the Fifth Circuit Court of Appeals decided in In re Chilton (674 F.3d 486 (2012)) that funds from an inherited IRA should be exempt. The U.S. Supreme Court agreed to resolve the conflict.
The U.S. Supreme Court affirms the Seventh Circuit’s decision in Clark, holding that the funds held in inherited IRAs are not “retirement funds.” In a unanimous opinion delivered by Justice Sotomayor, the Court finds that funds in an inherited IRA are not set aside for retirement because the holders of inherited IRAs cannot invest additional money in the account, are required to withdraw money from the account even though they aren’t close to retirement age, and may withdraw the entire balance of the account at one time.
This case highlights and enhances the reasons for using a stand alone IRA trust as the beneficiary of your IRA. A standalone IRA trust is a trust that you establish during your lifetime. It becomes the beneficiary of your IRAs. The individuals you otherwise would have named as the direct beneficiaries of the IRA will become the beneficiaries of the IRA trust. The IRA trust, because it is established by the IRA owner, for the benefit of other third parties – most typically spouses and children or grandchildren – the IRA trust can provide protection from creditor claims (protected asset), as well as protection from the beneficiaries’ potential proclivity to be a spendthrift and waste the asset that you have sacrificed during your lifetime to create.
The standalone IRA trust typically is a discretionary trust. That means the trustee that you name will have the ability to make distributions from the trust whenever the trustee deems it to be in the best interest of the beneficiary. You can provide guidelines and instructions to the trustee to direct how the assets of the trust will be used for the benefit of your beneficiaries. The standalone IRA trust can be used for other retirement accounts in addition to the IRA.
Typically, a standalone IRA trust includes what are called “accumulation” provisions. That means the trustee is not required to distribute out to the beneficiaries each year the required minimum distributions that are mandated by the Internal Revenue Code. Such a provision allows your IRA to be “stretched” over generations of beneficiaries rather than be used up by your children, if that is your desire (up to 360 years in Florida). This may be particularly useful with Roth IRAs because the required minimum distributions are not subject to income tax. Literally, the Roth IRA minimum required distributions can be distributed to the trust over the lifetimes of your children, pay no income tax, and your IRA will carry on in tact for successive generations (the income earned by the assets after distribution from the IRA will remain subject to income tax), without ever being subject to the income tax, based on current law.
One interesting side issue, as least for Floridians (as well as residents of Arizona, Alaska and Texas), is that in 2011, the Florida legislature enacted Florida Statutes, Section 222.21(2)(a). The referenced statute specifically provides that inherited IRAs are protected from creditor claims for Florida residents. Clearly, for state law purposes, the statute protects inherited IRAs from creditors in state courts. A person who has been a resident of Florida for at least 730 days, and who files for bankruptcy protection in Florida, may elect to have the Florida exemptions apply in bankruptcy and an inherited IRA will be protected in Florida.
Notwithstanding Florida’s position that such assets are protected under Florida law, if your beneficiaries live anywhere but Florida, then the Clark case clearly eliminates any protection that may have been possible prior to the decision. The standalone IRA trust will be the only effective means to ensure your IRA is protected from creditors (including divorcing spouses) for your spouses, children, grandchildren or other beneficiaries, after your passing. It is also the only option that will “guarantee” you that your Roth IRA can be transferred to future generations if that is your desire.
All of this sounds very complicated, but it really isn’t. We have prepared many standalone IRA trusts over the past several years and are very familiar with all of the tax nuances and beneficiary designation issues that are associated with standalone IRA trusts. If you think you would like to protect your IRA from your children’s creditors and divorcing spouses, or extend the value of your tax-free IRA for more generations than your children, we can help you design a standalone IRA trust that will meet your needs and desires. You can call our office to schedule a consultation to determine whether such a trust might be beneficial for you and your family.
For the full text of the Clark decision, go to: http://www.supremecourt.gov/opinions/13pdf/13-299_mjn0.pdf