If you were relying on the substantial creditor protections IRAs enjoy to shield inherited money from your creditors, it’s time to rethink that strategy. A Supreme Court ruling held that inherited IRAs do not enjoy the same bankruptcy protection as IRAs you funded with your own money.

This is going to be a big deal as aging baby boomers reach their will maturity dates, and their IRAs pass to their adult children and grandchildren.

The case arose from a claim against one Heidi Heffron-Clark, had inherited an IRA worth about who inherited an IRA worth over $450,000 from her mother in 2001.

She and her husband had started a pizza shop, which went under – like a lot of small businesses – in 2009. The restaurant’s closure resulted in a broken lease, and the landlord had a claim of $74,000. As a result of the business failure, the family declared bankruptcy in 2010.

Normally, IRAs are shielded against attachment by creditors – up to balances of $1.3 million under federal law. Some states provide even more protection. However, when Heffron-Clark’s creditors learned that she and her spouse had inherited a substantial IRA from her mother, they pounced.

Heffron-Clark’s attorneys argued that the law provided creditor protection to her IRA, and that the reason generally cited for these protections was equally valid for inherited IRAs and non-inherited IRAs alike: Society has a vested interest in enabling workers to provide for their own retirement security after their working years.

The bankruptcy trustee, on behalf of her creditors, countered by arguing that an inherited IRA did not qualify as “retirement funds,” under the meaning of the original statute. Indeed, they argued that if that were the intent behind the law they would place the same spending restrictions on inherited IRAs that they do with self-funded accounts. They do not. Indeed, the creditors pointed out that the law allowed them access to the money immediately, and the Heffron-Clark family had already spent $150,000 of the $450,000 they had inherited (possibly trying to keep the business afloat).

The 7^th Circuit Court of Appeals held for the creditors. Heffron-Clark appealed and the case went to the Supreme Court, which voted unanimously to uphold.

Sonia Sotomayor, writing the court’s decision, held that “The text and purpose of the Bankruptcy Code make clear that funds held in inherited IRAs are not “retirement funds” within the meaning of § 522(b)(3)(C)’s bankruptcy exemption.” Further, explaining the Court’s reasoning, Sotomayor writes: “if an individual is allowed to exempt an inherited IRA from her bankruptcy estate, nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete. Allowing that kind of exemption would convert the Bankruptcy Code’s purposes of preserving debtors’ ability to meet their basic needs and ensuring that they have a “fresh start,” Rousey, 544 U. S., at 325, into a “free pass,” Schwab, 560 U. S., at 791. We decline to read the retirement funds provision in that manner.”

You can read the full decision here.

So what does that mean? If you have spendthrift kids, or kids with severe debt troubles (this could include failed businesses that just didn’t get lucky), don’t leave them an IRA directly. Their creditors could come after it just like their other assets.

Instead, consider transferring the IRA proceeds to a trust, which limits their control of the money. Furthermore, the creditor claim is generally not going to be against the trust, which is a separate entity that generally has nothing to do with whatever created the debt in the first place, and so creditors will have no recourse against assets held in a properly-constructed trust.

It’s probably not going to be enough for the beneficiaries of the inherited IRA to create a trust and then transfer the funds after the fact: Case law tends to frown on “self-settled trusts” and provide much less in the way of creditor protections to trusts funded in this way.

American IRA, LLC does not provide legal advice.

Naturally, if you are in some debt trouble – or have some risk of liability even if you don’t have an immediate debt crisis or bankruptcy in process, you may want to have this conversation with your parents… and an experienced, qualified attorney.

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