How Advisors Can Protect Inherited IRAs

Individual retirement accounts – or IRAs – have become a popular way for many Americans to save for their retirement. By making it possible to invest with tax-free growth or on a tax-deferred basis, traditional and Roth IRAs have become among the largest financial assets owned by many households. These dynamics have led to some scrutiny concerning inheritance and related estate planning issues, and financial advisors and tax and estate planners should take note.

In June 2014, the U.S. Supreme Court ruled on a case involving protections for inherited retirement funds in bankruptcy. Clark v. Rameker concerned a woman who inherited $450,000 from her mother’s IRA and then filed bankruptcy nine years later with $300,000 remaining in the account. Under previous law, IRAs funded with annual contributions were protected from creditors up to $1.2 million.

The U.S. Supreme Court ruled on June 12, 2014, in a 9-0 opinion that funds held in inherited IRAs are not “retirement funds” within the meaning of 11 U.S.C. 522(b)(3)(c), and therefore not exempt from the bankruptcy estate. As a direct result of the ruling, many financial advisers and estate lawyers began speculating about the best ways to protect inherited IRAs. (For related reading, see: Tax-Saving Advice for IRA Holders.)

Protection Strategies

There are a few different ways to ensure that inherited IRAs are protected from creditors following the U.S. Supreme Court’s ruling. If a spouse is inheriting the IRA, the account can be rolled over into his or her own IRA, which then protects the money from creditors under the aforementioned laws. The situation grows more complicated when a non-spouse inherits an IRA. (For related reading, see: Tax Treatment of Roth IRA Distributions.)

Inherited IRAs cannot be mixed with a non-spouse’s own account, but instead, must be withdrawn within a limited timeframe. These withdrawals can trigger significant tax consequences, with annual income after the first $12,149 taxed at the top rate of 39.6%. Obviously, these costs can significantly reduce the value of the inherited IRA, while the account remains exposed to creditors in the meantime. (For more, see: How are IRA Withdrawals Taxed?)

Trusts – a fiduciary arrangement for a third party to hold assets on behalf of beneficiaries – may offer the best protection for non-spouses that inherit IRAs. In addition to protecting the assets from creditors, trusts can help significantly lessen the tax consequences of inheriting an IRA, since the law requires mandatory distributions in these cases for beneficiaries. (For related reading, see: Designating a Trust as a Retirement Beneficiary.)

Trust Structures

The two most popular trust options for protecting inherited IRAs are so-called see-through trusts and trusted IRAs. Depending on situation, these trusts provide non-spouses with the ability to limit their tax consequences and protect their assets.

See-through trusts – where the beneficiaries can be individually identified – cost between $1,500 and $5,000 to setup, which means that they are ideal for larger inherited IRAs of $500,000 or more. These trusts enable inherited IRA distributions to be taxed at the beneficiary’s individual rates, which is usually significantly lower than the top tax rate of 39.6% that would otherwise apply.

Trusted IRAs are lower cost option for smaller inherited IRAs. At a cost of a few hundred dollars and a 1% to 2% management fee, these trusts enable beneficiaries to stretch withdrawals over a greater timeframe. The trusted IRA also enables the owner (before they pass away or are incapacitated) to specify the timing and amount of distributions for several generations. (For related reading, see: Tax Treatment of Ineligible IRA Rollovers.)

The Bottom Line

With the U.S. Supreme Court's recent ruling that inherited IRAs aren’t protected against creditors in the event of a bankruptcy, financial advisors and estate planners will have to have a closer look at how inherited IRAs are handled. Spouses can simply rollover inherited IRAs into their own accounts, but non-spouses may want to consider alternative solutions, such as see-through trusts and trusted IRAs. Those structures represent two relatively straightforward options to protect against creditors and limit tax consequences.