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Are Funds in an Inherited IRA Protected in Bankruptcy?

Posted By Allmand Law Firm, PLLC || 11-Sep-2014

The Supreme Court finally addressed the issue of when an IRA does not count as a retirement account. For nearly ten years, the question of whether inherited IRAs are protected during bankruptcy has gone unanswered. Finally, the Supreme Court has answered it with a unanimous no.

In Clark v. Rameker, Heidi Heffron-Clark filed for bankruptcy nine years after inheriting her mother's IRA. When the case hit the Supreme Court, Justice Sonia Sotomayor wrote up the Court's finding that the account could not be protected from creditors during bankruptcy.

The opinion produced by the court asserts a legal difference between a retirement account that you have accumulated yourself and those you have inherited. The Court cites differences between the two accounts, such as that inheritors cannot even add money to the IRA. In most cases, they have to withdraw within five years of inheritance or withdraw at least a certain amount every year. However, these requirements typically do not apply to spousal IRA inheritance.

When you own your own IRA, it is set up specifically for retirement. You can add money to it and you do not have to withdraw. It is there so you can protect yourself when you are no longer able to work. According the Supreme Court, the fact that an IRA is this sort of protection justifies keeping it from creditors in the event of bankruptcy.

The funds in your IRA accounts and other retirement plans, such as 401(k)s and 403(b)s are not generally part of a will. You have to fill out specific forms either when opening the account or after the account is open in order to name a beneficiary. In the case of Heidi Heffron-Clark, her mother Ruth Heffron filled out those papers naming Heffron-Clark as the sole beneficiary of a more than $450,000 IRA. Clark died just a year after naming her daughter as the IRA beneficiary and Heffron-Clark filed nine years later, in 2010.

The IRA account in question was worth about $300,000 when Heffron-Clark filed for bankruptcy. She had withdrawn about $150,000 already. At that time, she asserted that the remaining funds were for her retirement and therefore should be protected. Her creditors disagreed and the court said that the funds should not be protected. She appealed at the U.S. District Court for the Western District of Wisconsin and had the decision reversed. The 7th Circuit Court of Appeals overturned that decision.

In light of Heffron-Clark's alleged financial struggles, it seems odd that she would go through this much litigation. It would reasonably run up a very large bill. Nonetheless, IRA inheritors now have concrete answers to help them develop financial strategies for the future based on the Supreme Court's ruling.

The case is different for spouses who inherit an IRA. They have one way to protect their funds that other inheritors do not. They can roll over the funds in their deceased spouse's IRA into one of their own and delay distribution of a traditional IRA until the age of 70½. Unfortunately, spouses still have to pay any early-withdrawal penalties if the money is withdrawn before the living spouse's IRA before he or she turns 59½.

Even with the risk of an early-withdrawal penalty, the strategy may be worth it. Without rolling over the funds, the IRA is considered inherited. Spousal IRA inheritors can keep the account without withdrawing anything until his or her spouse would have been 70½. The problem is that, if there is a bankruptcy, the money is not protected from creditors. If there is a risk of that happening, a rollover is the best way to protect that retirement money.

According to Gideon Rothschild of New York's Moses & Singer, all individuals can protect their heirs by naming a trust as the beneficiary as the IRA instead of a single individual. This protects any heir, be they are spouse, child or other. A lot of people turn to this method to protect the money they leave to their heirs. However, it is advisable to speak to financial experts about this before implementing the plan. There are a lot of legalities that the typical layman may find difficult to navigate.

The Supreme Court's decision does not affect your personal IRAs. You still have the protection of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 .

Categories: Bankruptcy
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