Last summer, the Supreme Court ruled that funds held in an “inherited IRA” are not retirement funds within the meaning of Section 522(b)(3)(C) of the Bankruptcy Code. This means, the accounts are subject to creditor claims in a bankruptcy.
The Supreme Court was asked to rule inherited IRAs remain retirement accounts once they’re inherited by the beneficiaries. The argument was simple, the suit explained. An individual IRA that’s passed down should maintain its characteristics and remain protected from creditors. The Supreme Justices disagreed – and they were in unity. The Court decided a beneficiary of an inherited IRA may never invest in the account and because withdrawals are required from these accounts, it lost the traditional characteristics. Finally, a holder of an inherited IRA may withdraw the entire balance of the account at any time, and for any purpose, without penalty, while a withdrawal from a traditional or Roth IRA prior to age 59-1/2 triggers a 10 percent penalty, unless an exception applies. This changed everything and affects not only Americans, but every business sector too – especially the financial services sector.
So what justification could the SCOTUS have? For starters, beneficiaries don’t have the benefit of adding money to the inherited IRA. Further, they’re required to begin taking distributions the year following their inheritance. Makes no difference how old they are. They also have the option of taking distributions after they reach 59 and one half years with no penalties.
The Heart of the Lawsuit
The lawsuit was filed after a woman filed for Chapter 7 bankruptcy protection, but also wished to ensure the inherited IRA was exempt from bankruptcy laws. The account was worth $300,000 and she argued it was a retirement account, albeit inherited, and should be protected.
The courts disagreed and it made its way to the Supreme Court. Last summer, the Court ruled. Since then, many have begun rethinking ways to protect their loved ones who might be a beneficiary at some point to their IRAs. For those who feel the beneficiary could lose it in bankruptcy or via lawsuits filed by creditors, it makes sense that they begin to rethink their options.
IRA Beneficiaries Confusion
Even though the SCOTUS ruling applies specifically to inherited IRAs, it doesn’t address whether or not it applies only to those beneficiaries who are non-spouses, such as a child or whether it applies across the board to include surviving spouses. There are those who are confident the ruling won’t apply to surviving spouses and even if it does, those spouses will maintain the option of simply rolling the IRA into their own.
It could be problematic in other ways, too. Let’s say your 35 year old son in law is one of your IRA beneficiaries. He inherits your IRA worth $500,000 and then is sued when his construction company goes under. Not only will the $500,000 be fair game for creditors, but he will then also have to pay the taxes on that money. Remember, it’s no longer a retirement account, so it’s open to that kind of scrutiny. Needless to say, in some instances, inherited beneficiaries will not only lose their inheritances, but they may also be subject to paying taxes when they’re already in a vulnerable financial situation.
It’s a challenging predicament with no easy answers. To learn more about protecting your assets and your beneficiaries, contact our offices today.
Ellen LaPlante
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