What Are the Dangers When I Inherited an IRA?

Contributed by Tim Berry, JD – Tax Attorney

Awhile back I wrote an article about how most people are not doing the proper planning for inheriting assets. This issue really came to light over some email correspondence with some bankruptcy trustees.

It seems a trustee had come across an inherited IRA and felt it didn’t meet the technical definition of an IRA for bankruptcy exemption purposes. Since the bankruptcy trustee didn’t believe the inherited IRA met the definition of an IRA for exempt asset purposes, the trustee is now filing a motion to take the inherited IRA away from the debtor.

Chances are the bankruptcy trustee is probably going to take Mom and Dad’s hard earned money away.

In fact, a large (very large) percentage of inherited IRAs out there are not only unexempt for bankruptcy purposes, but they probably aren’t exempt for “regular” state law purposes as well.

Please do not read something in my comments that is not there. I am not, repeat, I AM NOT SAYING inherited IRAs are no longer tax deferred accounts. That is a tax law issue with the IRS. As long as the proper steps were taken with the inherited IRA, it is still probably a tax advantaged vehicle.

However, when you start looking at the Asset Protection laws and rules, those same inherited IRAs probably do not have any protection and are up for grabs. Why?: The disparity between the federal tax code and state exempt asset laws. Below are some state definitions of what types of accounts are considered exempt accounts, and thus protected:

Wisconsin exempts, “Assets that are, held or amounts payable under any retirement, pension, disability, death benefit, stock bonus, profit sharing plan, annuity, individual retirement account, individual retirement annuity, Keogh, 401-K or similar plan or contract providing benefits by reason of age, illness, disability, death or length of service and payments made to the debtor therefrom.”

California, “A payment under a stock bonus, pension, profit-sharing, annuity, or similar plan or contract on account of illness, disability, death, age, or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor”

Illinois, “Sec. 12-1006. Exemption for retirement plans. (a) A debtor’s interest in or right, whether vested or not, to the assets held in or to receive pensions, annuities, benefits, distributions, refunds of contributions, or other payments under a retirement plan is exempt from judgment, attachment, execution, distress for rent, and seizure for the satisfaction of debts if the plan (i) is intended in good faith to qualify as a retirement plan under applicable provisions of the Internal Revenue Code of 1986, as now or hereafter amended [26 U.S.C. § 1 et seq.], or (ii) is a public employee pension plan created under the Illinois Pension Code, as now or hereafter amended [40 ILCS 5/1-101 et seq.]“

Do you have the right beneficiaries for your IRA?

In making the determination that inherited IRAs do not meet the definition of an exempt asset, the various bankruptcy courts amongst other things point out inherited IRAs are not retirement plans. The inherited IRAs were not created as a retirement benefit for the heirs. Additionally, the inherited IRAs do not provide benefits by reason of age. Yeah, these are distinctions that only an attorney could say with a straight face, but these are distinctions that now have precedent. The final nail in the coffin is citing a section of the tax code which states inherited IRAs cannot be “rolled over” in a tax free manner, nor can additional contributions be made to the inherited IRA. In effect the bankruptcy courts say an inherited IRA is an IRA in name alone and not able to avail itself of the exemptions granted to “regular” IRAs.

Moral of the story?

If you have built up and accumulated a large IRA or pension account you are just downright stoopid (sound it out) if you name individuals as the beneficiaries of the account. You are probably throwing any Asset Protection for the account right out the window.

Depending upon your circumstances, the better step would be to name a trust as the beneficiary. You can’t stop there either. The next decision is if you merely want the trust to be a conduit to the ultimate beneficiary and or you actually want the trustee to be able to determine when and where the beneficiaries receive distributions. Obviously the second option is better from an Asset Protection viewpoint.

Additionally, you are going to need to determine if you wish the trust to just pass through the tax liability to the beneficiaries, or if the trust will be a tax exempt trust. It pretty much goes without saying tax exempt has some pretty strong appeal.

If the ship has already sailed, that is to say, you already have an inherited IRA, you have a couple of options facing you. The first is to move the account over to an IRA Trustee which has a specialized IRA trust agreement. Sure, the IRA may not be considered an exempt asset, but an IRA is nothing more than a trust. If the trust agreement has the proper language in it, your fallback position could be the IRA is a spendthrift trust. Most IRA custodians and banks don’t have this language, so if you want to go this route, give us a call.

Another option is to structure the underlying investments within the IRA so that even if the IRA is awarded to someone, the award is meaningless. What do I mean by this? Consider putting exempt assets within the asset that is no longer exempt. Annuities would work here, both “regular” and private. Long term promissory notes, investments in protected entities, etc. . .

In closing, there is an age wave that will be crashing against retirement accounts very shortly. Trillions of dollars are going to be passed down to the next generation. You are going to be presented with a precious opportunity to either provide strong Asset Protection Planning to your heirs and beneficiaries, or if you are on the receiving end, to discuss with your benefactors the proper way for them to leave a legacy and protected from frivolous lawsuits. If you don’t take the right steps, all the money that has been built up over all those years could very well be lost.

Tim Berry, JD

For more info about Tim and the Asset Protection Society, go to their website: http://www.assetprotectionsociety.org/