Inherited IRAs and Bankruptcy: When is an IRA not an IRA?

If you have an inherited IRA or think you might be leaving your IRA to your heirs, this article is for you.

The Bankruptcy Code excludes retirement investments from a bankruptcy estate as long as those investments are held in accounts that are exempt from taxation. However, on June 12^th in a unanimous decision upholding a decision of the Seventh Circuit Court, the U.S. Supreme Court ruled that funds in an inherited IRA were not retirement funds exempt from a debtor’s bankruptcy estate, because inherited IRAs do not operate like retirement accounts. According to local estate planning and collaborative law attorney, Shane Stibora, “you work hard for your assets and you want those assets to be used to help your children and grandchildren, not used to pay off a creditor in bankruptcy.  This Supreme Court case adds yet another complication in working to protect your assets.”

It boils down to the opinion that inherited IRAs are “a pot of money that can be freely used for current consumption… not funds objectively set aside for one’s retirement.” (quoting the Seventh Circuit Court) The Supreme Court sited three main points why an inherited IRA is not a “real” IRA.

1. As an owner of an inherited IRA, you cannot make additional contributions to this IRA.
2. You must take required distributions from your inherited IRA regardless of how close or how far you are from retirement.
3. You are not subject to any age-related penalties for withdrawals from this IRA.

The Supreme Court rejected the debtor’s argument that the account was originally a retirement account and should retain that status even after inheritance, stating that the account was set up by an entirely different person.

You may think that being an upstanding citizen you will never be bankrupt. Let’s look at the top five causes of bankruptcy.

1. Medical Expenses. According to a Harvard University study, medical expenses are the cause of 62% of all bankruptcies. Interestingly, 78% of these bankruptcy filers had some kind of health insurance. Serious diseases or injuries can easily mount up hundreds of thousands of dollars of medical bills, thus wiping out savings and retirement. Stibora adds that “in a situation where one of your heirs is likely to face a medical bankruptcy, it may be prudent to adjust your estate plan and not distribute any portion of a retirement account to that heir.”
2. Job Loss. The loss of income can be devastating. Not having a sufficient emergency fund can exasperate the problem. Loss of income is not the only problem. The loss of health insurance coverage can drain family resources.
3. Poor or Excess Use of Credit. Those who do not control their spending are more likely to land in bankruptcy court. Payments on credit cards, installment debt, vehicle loans, and the like can spiral out of control when you eventually cannot even make the minimum payments.
4. Divorce. Splitting up creates a huge financial strain on both spouses. The legal fees can be large. Child support and spousal support payments can inhibit the ability to pay the rest of living expenses.
5. Unexpected Expenses. Theft or casualty such as earthquakes, floods, or tornadoes can devastate a property owner who is not insured. Many homeowners do not realize they need to have separate coverage for certain events like earthquakes. They can lose their homes plus all contents, including wardrobes required to retain their jobs.

What does this mean to you? If you declare bankruptcy while you still own an inherited IRA, those funds will not be protected under federal law. Your chances of getting any protection from creditors for those funds (whether inside or outside of bankruptcy) will now depend on the laws of the state in which you reside.

However, if you inherit an IRA from your deceased spouse and you are the sole beneficiary, you are generally entitled to treat that inherited IRA as your own. You need to make an affirmative election or contribute to the account to do so. When you do, the IRA will not be considered an inherited IRA for the purposes of bankruptcy. The case ruled by the Supreme Court involved an IRA inherited by the deceased owner’s daughter, not a spouse.

Keep all of this in mind when you are naming the beneficiaries of your own IRA – especially if you are thinking about naming someone other than your spouse as your beneficiary. If you are concerned about protecting your heirs from creditors, consider naming a spendthrift trust as your IRA beneficiary. However, be careful to consult a qualified professional first, because going this route can have significant legal and income tax implications.

As Stibora warns, “It is important to have a plan for your estate and review that plan regularly, especially if there has been a change in your life or the life of any of your heirs.  You must consider the possibility of a bankruptcy for your heirs in your estate planning and develop a plan to protect your assets.”