U.S. Supreme Court Rules that Inherited IRAs are not Protected from the Claims of Creditors

On June 12, 2014, the U.S. Supreme Court unanimously held in Clark v. Rameker that the protection afforded individual retirement accounts under the Bankruptcy Code is lost once such accounts are inherited.  The reason given is that the account loses its traditional character as “retirement funds.”  While it seems clear that an IRA inherited by a non-spouse is now no longer protected, it is unclear whether the protection is also lost if a spouse inherits the IRA.

The Court concluded that an inherited IRA did not constitute “retirement funds” in the hands of the beneficiary by citing the following limitations imposed on inherited IRAs.  Such limitations do not exist for IRAs that are owned and not inherited.

1.     The beneficiary cannot contribute money into the inherited IRA.

2.     The beneficiary must begin minimum required distributions from the inherited IRA and cannot wait until the beneficiary’s own retirement.

3.     The beneficiary may withdraw the entire inherited IRA balance without an early withdrawal penalty if under age 59 ½.

A spouse beneficiary has the ability to roll over the inherited IRA to his or her own personal IRA, whereas non-spouse beneficiaries are unable to do so.  This fact brings up a few important questions: Will this rollover allow the inherited funds to be protected under the Bankruptcy Act?  Or, will the protection not be permitted because the spouse did not set aside such money him or herself?  We may not know the answer to these questions without future litigation.

IRA owners should now consider naming a discretionary trust as beneficiary.  Giving the trustee discretion on how and when to make distributions to beneficiaries may enhance creditor protection.  The trust must be properly drafted to qualify as a designated beneficiary to avoid unfavorable income tax results upon the IRA owner’s death.

This case deals with Federal bankruptcy law.  State law may nevertheless provide some protection to an inherited IRA.  Individuals with large IRA balances who are concerned about asset protection should consult with their attorney.