Creditors Can Claim Your IRA Distribution to Your Child

It is one of the things that parents fear the most when discussing Estate Plans: losing a part or all of an inheritance they leave for their child to divorce, lawsuit, or creditor.

If there was some thought that an inherited IRA was protected from such action, the Supreme Court made it clear June 14, 2014 it is not in their unanimous decision in Clark v. Rameker. This case came from the 7th Circuit Court of Appeals. That is the the Federal Circuit of which Indiana find itself located, so this was already the “law of our land.” Now everyone else in the country gets to follow along (except a few states which have passed some specific exemptions to this situation.)

Here’s what happened in the Supreme Court case rising from Wisconsin:

In 2000, Ruth Hefferon created an IRA, naming her daughter, Heidi Hefferon-Clark, as the sole beneficiary. When Ruth died in 2001, Heidi inherited the IRA then worth $450,000 from which she elected to take monthly distributions. When Heidi and her husband filed Chapter 7 bankruptcy in 2010, they claimed the Inherited IRA, then worth $300,000, was exempt from consideration. The creditors and bankruptcy trustee thought otherwise and the suit ensue.

Initially, the Bankruptcy Court ruled it was not exempt under 11 U. S. C. §522(b)(3)(C). The Western District of Wisconsin Federal District Court reversed that ruling. In re Clark, 466 B. R. 135, 139 (WD Wisc. 2012). The 7th Circuit returned the volley back in favor of the Bankruptcy Court citing the differences between an inherited IRA and an IRA that is still a retirement vehicle. In re Clark, 714 F. 3d 559 (2013).

That decision from the 7th conflicted with a 2012 ruling from the 5th Circuit (discussed in this article Kenneth Petersen, Financial Planning: The Supremes Rule on Inherited IRAs), which put the issue square in the crosshairs of the Supreme Court, argued March 24, 2014. Justice Sotomayor delivered the unanimous decision which clarified the difference between IRA funds, in the form of an inherited IRA, and those IRA funds which are held in a qualified – read tax deferred status – for the benefit of the individual saving the funds or for his or her spouse. The Court found funds from an inherited IRA were not encumbered with the same penalty provision for early withdrawal, and in fact, had to be withdrawn beginning in the year after the death of the IRA originator. Further distinguishing the IRA funds is the fact that the owner of an inherited IRA can not add any additional funds or mix the inherited IRA with his/her own IRA accounts.

This was enough to show that the Inherited IRA is not a protected retirement fund and therefore subject to a creditor’s action.

All is not lost though. There are a handful of states that have passed provisions establishing Inherited IRAs as protected from bankruptcy, though it will be interesting to see if a creditor has a chance to challenge that state statute now that the Supreme Court has made this ruling.

The other provision to protect your IRA distribution in a proactive manner is to establish an IRA Preservation Trust. If you have highly appreciated IRAs that you will not be reducing dramatically during you or your spouse’s lifetime, contact Rice & Rice Attorneys to learn more about this Estate Planning vehicle.