Inherited IRAs Not Protected In Bankruptcy

By Deborah Jacobs, Forbes

When is an IRA not a “retirement” account?

The U.S. Supreme Court answered that riddle recently and resolved a key question that has lingered for nearly a decade: Are funds in an inherited IRA protected in bankruptcy? The answer was a unanimous, “No.”

In an opinion with far-reaching implications, the Court found that Heidi Heffron-Clark, who inherited an IRA from her mother in 2001 and filed for bankruptcy nine years later, could not shield the account from her creditors.

The Court’s analysis turned on key legal distinctions between inherited IRAs and those that you set up and fund yourself, either through annual contributions or by rolling over assets from a company plan.

Several features make inherited IRAs unique and suggest that they are not retirement assets, the Court noted. Unlike IRA owners, inheritors can’t put additional funds into the account, and they can take out money at any time without penalty. In fact, generally, non-spousal IRA heirs must either withdraw the entire account balance within five years of the original owner’s death, or take out a minimum amount each year, starting by Dec. 31 of the year after the IRA owner died.

This whole system is different from the one that applies to IRA owners, which is designed to ensure that they will have money available during retirement, and therefore justifies protection of those assets during bankruptcy, the Court noted.

Money in IRA accounts (or employer sponsored retirement plans, such as 401(k)s and 403(b)s) will not normally be covered by a will. Instead, an IRA inheritance is given out according to beneficiary designation forms that you fill out when you open the accounts or later amend.

Most notably the decision has important ramifications for spouses. A spouse who inherits–let’s assume it’s the wife–has an option not available to other inheritors. She can roll the assets into her own IRA and postpone distributions from a traditional IRA until she turns 70½. The catch is, like other IRA owners she may have to pay a 10% early-withdrawal penalty if she takes money before age 59½ from her own IRA, as explained here.

Unless she does the rollover, however, the account is considered an inherited IRA. She would not have to take any money out until her late spouse would have turned 70½. But under today’s decision those assets would not seem to be protected in bankruptcy. So spouses now have one more reason, in addition to income tax benefits, to do a rollover.

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