Inherited IRAs Are No Longer Absolutely Safe From Bankruptcy Claims

The U.S. Supreme Court decided that inherited Individual Retirement Accounts (IRAs) do not qualify as retirement funds and are not exempt from claims of creditors under the Bankruptcy Code §522(b)(3)(C). The Supreme Court resorted to the plain meaning of the words and held that retirement funds are sums of money set aside for an individual when he or she stops working. Under that view, IRAs may be divided into two types, ordinary and inherited. An ordinary IRA is exempt up to $1,245,475 and has a cost-of-living adjustment. There are additional exceptions for SEPs or SIMPLE IRAs which are not subject to the limitation. Rollovers from an ERISA qualified plans into an IRA are not counted toward the exemption limit.

IRAs passing to spouses and children had been considered retirement funds, safe from bankruptcy, claims before the 2014 Supreme Court decision in Clark v. Rameker. The decision requires one to look at the Bankruptcy Rules that may apply. A debtor in Bankruptcy may choose between the exemptions offered by the Bankruptcy Code or those offered by the state of the debtor’s residence. Certain states, such as Alaska, Missouri, North Carolina, Ohio, Texas and Florida, adopted state law exemptions that protect IRAs. Wisconsin, the state of residence for the Clarks, adopted the federal exemptions, so there was no choice. Clearly, state law makes a difference.

New Jersey law exempts assets held or maintained in a “qualifying trust” and broadly defines the term to include trusts holding retirement plans, 529 plans and IRAs to name some. Why, you ask, are we concerned if we live in New Jersey?

I estimate that about only one-half of adult children, identified in our recent estate plans, reside in New Jersey. If a child is named as beneficiary of an IRA, it is the law of the child’s state of residence that will control the outcome. No one can predict where a child may reside or what state law might be in the future. The solution offered by some is the “Trustee IRA.” We must consider a beneficiary’s potential future creditors if an estate plan is to effectively transfer wealth to the intended beneficiaries.

The trust; however, cannot be a conduit trust. The trust must have the ability to accumulate income. Accumulation trusts for IRAs were not well received because trust income tax rates are higher than individual rates and because Minimum Required Distributions (MRD) for a group of beneficiaries were calculated using the life expectancy of the oldest living beneficiary. MRD rule discouraged the use of one accumulation trust for a group of beneficiaries of varying ages. Clients are not fond of the increased costs for separate accumulation trusts and portfolio management is inefficient.

State trust law also impacts asset protection. In Tannen v. Tannen, a New Jersey divorce case, I described the impact between different versions of the Uniform Trust Code upon the ability of a beneficiary or a creditor of the beneficiary to demand distribution that a trustee with discretionary authority distribute funds. This may necessitate flight or situs clauses that sacrifice efficiency for asset protection.