The Ins and Outs of Bankruptcy Protection for Self-Directed Inherited IRAs

IRAs enjoy a tremendous amount of protection when it comes to bankruptcy and the claims of creditors. But it’s not the same for all IRAs, and it’s not the same in all states. Depending on the jurisdiction, Self-Directed Inherited IRA assets may be subject to seizure in the event of a judgment. If you have a large Inherited IRA, or you have reason to believe you may go bankrupt in the future or you may be subject to a lawsuit involving a substantial sum of money that could be life-changing if you received a judgment, it’s a good idea to take stock of the law in your state before making any major decisions.

The general limit

Normally, IRAs are protected from creditors, up to a limit of $1,283,025. This amount is adjusted every three years according to the cost of living, and the next adjustment is due some time in 2019. Qualified workplace retirement plans, like 401(k)s and 403(b)s, enjoy even greater protection: They have no dollar caps on the amount that is protected from creditor claims.

Furthermore, any assets that you accumulate within a 401(k) that you later roll over into an IRA, including a Self-Directed IRA, also enjoy unlimited creditor protection nationwide. So, if you have a substantial 401(k) balance from a prior employer and you are interested in rolling it over into an IRA or Roth IRA, you do not have to worry about losing creditor protection.

However, a 2014 Supreme Court decision, Clark v. Rameker, the Justices unanimously held that Inherited IRAs did not warrant the same level of creditor protection extended to self-funded IRAs.

Their ruling was that Self-Directed Inherited IRAs do not qualify for the status of retirement plans under federal bankruptcy law and are fair game for creditors seeking damages. The court’s reasoning was three-fold:

  • Unlike retirement plans, Self-Directed Inherited IRAs do not allow further contributions.
  • Unlike non-inherited IRAs, Inherited IRAs can be liquidated at any time and for any reason, without penalty. Other IRAs are subject to a 10 percent penalty for early withdrawal, except for specific hardship circumstances.
  • Self-Directed Inherited IRA owners have to withdraw all their account funds within five years of inheriting the assets, or begin taking minimum distributions every year, regardless of how far from retirement the inheritor is.

The courts held that once an IRA is inherited by a beneficiary other than a spouse, it no longer contains funds that were set aside specifically for the purposes of providing for retirement security, and therefore should be treated the same as all other assets when it comes to creditor protection.

So, under the federal system, Self-Directed Inherited IRAs are subject to creditor claims and may be seized in the event a creditor obtains a judgement and a court order to that effect.

But when it comes to bankruptcy proceedings, not every state is under the federal system. A number of states have opted out of the federal system and give debtors a choice between handling bankruptcies under federal or state guidelines.

Those states that have opted out of federal bankruptcy rules may have exemptions that are much more favorable to those with Self-Directed Inherited IRAs, and for those with IRA balances that exceed the current limit of $1,283,025.

Currently, these states include Arizona, Alaska, North Carolina, Missouri, Florida, Texas, and Ohio. A more detailed chart can be found here.

This issue does not just affect those who have Self-Directed Inherited IRAs. Parents in or nearing retirement whose children have legal issues or are chronic spendthrifts may also want to take measures to set up a trust to inherit assets, rather than passing IRAs directly on to their children where they would be quickly gobbled up by creditors, depending on the state.

American IRA does not provide individualized legal advice. For information pertaining to your individual situation, you should consult a qualified attorney licensed in your state with experience in bankruptcy law.

Interested in learning more about Self-Directed IRAs?  Contact American IRA, LLC at 866-7500-IRA (472) for a free consultation.  Download our free guides or visit us online at www.AmericanIRA.com.

Things You Need to Know About a Self-Directed Inherited IRA

It is estimated that $30 trillion of intergenerational wealth will be passed down over the next decades, creating both opportunities and risks those inheriting these potentially large sums of money. Some of these transfers will come in the form of a Self-Directed Inherited IRA (a.k.a. a Beneficiary IRA), which will allow inheritors/beneficiaries to manage these inheritances that are passed down to them in the form of a retirement account.

Self-Directed Inherited IRAs allow the deceased account holders to pass along tax-advantaged savings to their heirs. Unfortunately, the first time most recipients become aware of a Self-Directed Beneficiary IRA is when they suddenly inherit a retirement account. Since it is someone else’s retirement plan, a Self-Directed Inherited IRA can be confusing to those who receive it, and it can generate many questions: What are my options with this account? What about taxes? How can I merge this inheritance into my own financial plan?

As baby-boomer heirs participate in the largest wealth transfer in history, it is more important than ever that they understand the details of the Self-Directed Inherited IRA. First of all, you will need to distinguish between a Self-Directed IRA you inherit from your spouse and one you inherit from a parent, sibling or someone else.

Here is what you need to know:

Inheriting a Traditional IRA from your spouse

Inheriting a Self-Directed IRA from your spouse is the simplest and most pain-free scenario. You can roll over the Self-Directed Inherited IRA into your existing IRA, and the earnings will continue to grow tax-deferred. You will pay no income taxes unless you take a distribution, and if you are older than 59 ½, you won’t owe the 10% tax penalty on early withdrawals.

Rolling over a Self-Directed Inherited IRA is attractive because you immediately gain control over the distributions. A word of caution, however: If you are at least 70 ½, make sure you adjust the amount of your annual Required Minimum Distribution (RMD) to include the amount from the Inherited IRA. Some special RMD rules apply to Self-Directed Inherited IRAs, and there are steep penalties for not following them!

Also, remember that if you do decide to take a Self-Directed Inherited IRA distribution, it could send you into a higher tax bracket because the money will now be earned income. If you would rather invest the money, talk to your financial advisor about incorporating the inheritance into your overall financial plan.

If you are a non-spouse inheritor

You will need to pay income taxes on distributions from the Inherited Traditional IRA. But you may not roll the Self-Directed Inherited IRA into an existing Self-Directed IRA, and you must begin withdrawing the assets no later than December 31st of the year after the account holder passed away.

Once again, these distributions are considered to be part of your annual income and could put you into a higher tax bracket. And if you do not take the necessary distributions, you will suffer a 50% tax penalty on the amount taken out below the RMD!

Self-Directed Inherited IRA distribution rules

Beneficiaries of Self-Directed Inherited IRAs can choose distributions from three options:

  1. Take distributions as an RMD over the course of their lifetime (life expectancy method)
  2. Take them over a five-year period
  3. Receive a lump sum.

The life expectancy option means an RMD will be set each year by the IRS, and you must make them to avoid the penalty.

The five-year option allows you to withdraw the funds over five years. There are no RMDs, and there is no early withdrawal penalty. After five years, all remaining funds must be withdrawn.

The lump sum distribution means a full payout of the account immediately after inheriting the Self-Directed IRA. While there is no 10% early withdrawal penalty, you will still owe income taxes.

What are the rules for Self-Directed Roth IRAs?

Since the Self-Directed Roth IRA was funded with post-tax income, the inheritor will not pay income tax on distributions, and the distributions will not count as taxable income when determining your tax bracket.

If you elect to take the life expectancy method, however, any distributions that fall below the RMD will still be subject to the 50% penalty.

Turn to the pros when you are ready to invest your Self-Directed Inherited IRA

At American IRA, we believe that Self-Directed IRAs are the best vehicles for growing your retirement account. And we have the experience to help you with your transactions.

Interested in learning more about Self-Directed IRAs?  Contact American IRA, LLC at 866-7500-IRA (472) for a free consultation.  Download our free guides or visit us online at www.AmericanIRA.com.