Supremes: Inherited IRAs Fair Game for Creditors

Inherited IRAIf 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 7th 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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Preserving Benefits for Inherited IRA

Inherited IRAOne of the primary benefits of saving in an IRA is the tax-deferred growth on earnings, which provides the compound effect of earnings-on-earnings.  You can benefit even more with a Roth IRA because these earnings can be tax-free.  Unfortunately, this tax benefit is often severely diminished by beneficiaries who make mistakes when handling inherited IRAs. Avoid these errors by taking some simple steps with any IRA that you inherit.

Avoid Unintended Distributions

One of the most common and costly mistakes made with inherited IRAs occurs when a beneficiary requests a distribution when the intent was to transfer the assets. This often occurs when the beneficiary completes the wrong type of paperwork or mistakenly believes that the amount can be rolled over. If you make an unintended distribution, the amount would be included in your ordinary income for the year and therefore would no longer be eligible for tax-deferred (or tax-free in the case of a Roth IRA) growth. The amount could also put you in a higher tax bracket, which may subject your other income amounts to a higher tax rate.

Solution:  When moving assets to your inherited IRA, ensure that the paperwork is for a transfer and not a distribution. Once the assets are distributed from the IRA, they are no longer eligible to be held in an IRA or other tax-deferred retirement account. An exception applies if you are a surviving spouse, as spouse beneficiaries can rollover these amounts to their own IRAs.

Take RMD Amounts

If the IRA owner died on or after reaching the required beginning date (RBD), a required minimum distribution (RMD) must be taken from the IRA for the year that he died. If he did not take this RMD amount, then you must withdraw that amount by the end of the year.  You may also be required to take your own “beneficiary” RMD for IRAs that you have inherited. Failure to take these RMD amounts by the applicable deadline will result in you owing the IRS a 50% excess accumulation penalty.

Solution: Ensure that all RMD amounts are withdrawn before the deadline. If you are unsure about whether you need to take an RMD, contact our offices as soon as possible.  If you missed the deadline due to reasonable causes, the IRS may waive the excess accumulation penalty.

Split Timely for Multiple Beneficiaries

Generally, multiple beneficiaries of an IRA are required to use the life expectancy of the oldest beneficiary when computing beneficiary RMD amounts. This can severely reduce the tax-deferred benefit for the younger beneficiaries, when the oldest beneficiary is much older or the beneficiaries include a non-person such as an estate or charity. For instance, a 45-year-old beneficiary’s distribution period can be reduced from 38 years to five years, if he is one of multiple beneficiaries of an IRA owner who died before the RBD, and one of those beneficiaries is the decedent’s estate.

Solution:  If you are one of multiple beneficiaries, segregate your share into a separate account by September 30 of the year that follows the year in which the IRA owner dies if one of the beneficiaries is a nonperson such as an estate or charity. The deadline is extended to December 31 of the year that follows the year in which the IRA owner dies if there are no non-person beneficiaries.

Work With an Advisor Who Understands IRAs

The rules by which IRAs are governed are many, varied, and often complicated. The assistance of a financial professional who is knowledgeable about IRA rules and regulations can help you to avoid irreversible errors and maximize your tax benefits.

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Why Self-Directed IRAs Must Be Handled With Professional Care

Self-Directed IRAWith the wealth of information available about Self-Directed IRAs on the internet and elsewhere, it is tempting to believe that such information provides sufficient guidance for the proper handling of your IRAs. However, as many have found out at great cost, handling IRAs without the assistance of a professional who is knowledgeable about how IRAs work is risky behavior. The following are just two of the many examples that are available:

10 Percent Rule Misapplied: The Case: Peggy Ann Sears v. Commissioner, T.C. Memo. 2010-146

Distributions from retirement accounts are subject to a 10 percent additional tax (early distribution penalty), unless an exception applies. One of the exceptions applies to amounts withdrawn from an Inherited IRA.  This rule may seem simple. However, it gets complicated for spouse beneficiaries because a Self-Directed IRA that is inherited by a surviving spouse is not necessarily an inherited IRA. Here’s why!

When a surviving spouse inherits an IRA, he (or she) has the option of treating the amount as her ‘own’ IRA by moving the amounts to her own non-inherited IRA, or she may keep the amount in an inherited IRA. If the amount is kept in an inherited IRA, distributions from that inherited IRA are ‘death distributions’, which are not subject to the 10 percent early distribution penalty, regardless of the age at which the distribution is made. On the other hand, if the amount is moved to her ‘own’ IRA, the ‘death distribution’ exception no longer applies. In the case of Peggy Ann Sears v. Commissioner, T.C. Memo. 2010-146, Peggy found this out the hard way when she moved her deceased husband’s IRA into her own IRA and subsequently made withdrawals before she reached age 59 ½. Peggy did not pay the 10 percent early distribution penalty on the amount when she filed her tax return, because she thought the amount was a ‘death distribution’. The IRS amended her tax return to show that she owed the penalty, which amounted to $6,093.70.

Rule for Tax Treatment of IRA Earnings Misapplied:  Robert L. Bernard and Diolinda B. Abilheira  vs U.S. Tax Court T.C. Memo. 2012-221

Amounts withdrawn from an IRA are treated as ordinary income and any pretax amount is taxed at the owner’s ordinary income tax rate. However, the taxpayers in the case of Robert L. Bernard and Diolinda B. Abilheira vs. U.S. Tax Court felt differently and applied the (lower) capital gains treatment to amounts that they withdrew from various IRAs. They claimed that because capital gains within their IRAs increased the value of those accounts, they are entitled to report the distributions received as capital gains. They also contended that capital gains within the accounts “increased the cost basis” of shares.  However, the IRS disagreed and amended their tax return, which resulting in them owing a penalty of $8,179.

Let us Guide You

With the availability of seemingly endless sources of information about Self-Directed IRAs, you might be tempted to feel you have enough knowledge to handle your IRA transactions without assistance. But as you know, practical experience is often needed to help ensure proper application of the rules. Please contact us before initiating transactions that could put your retirement savings at risk of unintended taxes and avoidable penalties.