Inherited IRAs Can Be Taken From the Beneficiary
Last month, in its unanimous decision in Clark v. Rameker, the United States Supreme Court decided that an inherited IRA does not have the same bankruptcy protection as a non-inherited IRA. In that case, Heidi Clark-Heffron inherited a $300,000 IRA account upon the death of her mother. When Clark-Heffron's business subsequently failed, she filed for bankruptcy under Chapter 7. She argued that the IRA she had inherited was a retirement account and thus protected from creditors under federal bankruptcy law. But the Supreme Court ruled against her, concluding that an IRA inherited by a non-spouse is not a "retirement account."
Unlike an IRA that a person sets up for themselves, contributes to and withdraws from at retirement age, or an IRA passed to a spouse and rolled over by the spouse, the funds in an inherited IRA may be withdrawn without penalty at any time before retirement age, and in fact some withdrawals are mandatory regardless of the individual’s age or length of time from anticipated retirement. Additionally, the person inheriting the IRA may not make further deposits to that account. All of these factors indicate that the inherited IRA is not truly intended to provide benefits to sustain the inheritor during their retirement years. Thus, the court determined that an inherited IRA has effectively lost its status as a retirement account and is simply a "pot of money that can be freely used for current consumption" and that does not merit any special protections.
Why is this important? The impact of Clark goes far beyond just those individuals compelled to navigate the bankruptcy laws. For many of our estate planning clients, an IRA or other type of retirement account is often one of, if not the largest, asset they own. The lesson of the Clark decision is that another dimension has been added to the estate planning discussion.
The tax code provides a surviving spouse of a deceased account holder with several different options for receiving an IRA account. The surviving spouse can elect to take the account as an “inherited IRA,” meaning to a certain extent the IRS will consider that account as still being that of the deceased account holder, or the surviving spouse can “roll over” the IRA, moving the funds into another account established by the surviving spouse in their own right. In those situations, we have considered issues such as when the spouse will need to draw on those funds, and the value of the IRA in light of the surviving spouse’s other liquid and non-liquid assets. Now that discussion will need to include the apparent loss of creditor protection that would result if the surviving spouse chooses to hold the IRA funds as an inherited IRA, although that precise issue was not addressed in Clark.
Furthermore, before Clark parents could have been reasonably confident that IRA funds they leave to their children after they die would be protected from creditors. That protection has now been nullified. Anyone intending to leave an IRA to their children should take steps without delay to protect the funds from their child's creditors. For many clients, the importance of establishing spendthrift trusts for one’s children or other loved ones is now even more compelling.
What is left unclear is how the Supreme Court’s Clark decision will integrate with various state IRA / bankruptcy protection statutes. For example, the Connecticut General Statutes protects assets held in an IRA account from the claims of creditors (see C.G.S. §52-321a). The words of that statute state that protection is afforded to “a participant or beneficiary” of a retirement account. The term beneficiary would seem to address someone who inherited a retirement account, which is precisely the factual scenario adjudicated in Clark, but that term is not truly defined in the state statutes. It not yet clear whether that federal decision in any way modifies the scope of state protection statutes such as that of Connecticut.
We urge all of our clients and financial advisors with whom we collaborate to call or come in to discuss these issues.