Inherited IRAs: Not Considered “Retirement Funds” Anymore
As of the first quarter of 2014, investors in the United States held approximately $6.6 trillion in individual retirement accounts (IRAs), according to the Investment Company Institute. On June 12, the Supreme Court issued a ruling directly affecting beneficiaries of these accounts. The Supreme Court held that funds contained within inherited IRAs do not qualify as exempt under 11 U.S.C. § 522(b)(3)(C). This means that for the purposes of a federal bankruptcy, an inherited IRA will not be treated as “retirement funds” and consequently is not protected from creditors’ reach.
An inherited IRA is a traditional or Roth IRA that has been inherited after its owner’s death. Inherited IRAs do not operate like ordinary IRAs. An individual can withdraw the entire balance at any time — and use it for any purpose — without penalty. However, the owner must withdraw the funds by either taking the entire balance within five years of the original owner’s death or taking minimum distributions annually. Additionally, the owner of an inherited IRA is never allowed to make contributions to the inherited IRA account.
The Supreme Court reasoned that the ordinary meaning of “retirement funds” is properly understood to be the sum of money set aside for the day an individual stops working. The Supreme Court concluded that nothing under the governing rules of inherited IRAs requires or encourages these funds be used for the current owner’s retirement. Consequently, the court held that inherited IRAs do not qualify for the exemption under the code and are an includable asset within the bankruptcy estate provided no other exemptions are applicable.
It should be noted that this ruling only affects federal bankruptcies and does not directly affect state bankruptcy laws in any respect. Each state has its own set of bankruptcy laws that can substantially differ from the federal bankruptcy code. Some states currently provide co-equal protection to regular IRAs and inherited IRAs alike, and some do not. The Supreme Court’s ruling, however, will almost certainly influence states’ thinking on the matter because it was a unanimous court decision. Unanimous decisions tend to carry persuasive weight with states because it is, in essence, an entire branch of the federal government speaking with a single, uniform voice — not a common occurrence in this day and age.
This change provides a good moment to think about estate planning issues with respect to our IRAs. Trusts can be particularly good vehicles to provide asset protection to beneficiaries. As with any planning device, your individual situation will dictate what is necessary and appropriate. This situation, however, does give us some clear guidance as how to best protect these assets for the benefit of you and your families, and it provides an opportune time to review estate plans.
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