How to Protect an Inherited IRA Against Creditors
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provides that traditional IRAs and ROTH IRAs resulting from contributions are protected from creditors in a bankruptcy situation up to $1,000,000. Rollovers from qualified retirement plans have unlimited protection in bankruptcy. For all other situations and judgment creditors, state law governs. State laws vary, of course, but Massachusetts allows up to $1 million to be protected from judgment creditors.
So, you ask, what if the IRA account is over $1 million and you want protection against judgment creditors? You need to set up a trust. What if the IRA account is under $1 million and it is an inherited IRA? You need to set up a trust. Here’s why.
State Court Cases
According to research done by Seymour Goldberg, CPA, MBA, JD, a senior partner in the New York law firm of Goldberg & Goldberg, P.C. specializing in retirement planning, the issue of whether a nonspouse IRA beneficiary/owner of an inherited IRA gets creditor protection has been tried six times in state courts, including bankruptcy courts. Each time the nonspouse IRA beneficiary/owner lost creditor protection. To be fair, five of the six cases were decided before the Bankruptcy Abuse Act of 2005. In the sixth case decided after the Bankruptcy Act became effective, a Texas court didn’t even reference the Act, but instead, looked to state law precedent to rule against the nonspouse IRA beneficiary/owner.
These courts have pointed out that if the inherited IRA beneficiary/owner had been a spouse, their rulings would have been different because the spouse has the right to rollover the IRA into her own name. Nonspouse IRA beneficiaries cannot do a rollover to their own names without terminating the IRA. Thus, the inherited IRA account for the benefit of a nonspouse is exposed to creditors, whether in the IRA or terminated through withdrawal or rollover.
The Irrevocable Discretionary Trust
To obtain creditor protection for the nonspouse IRA beneficiary, the only safe solution is to setup an irrevocable discretionary trust, name the trust as beneficiary of the IRA, and appoint an independent trustee with discretionary authority as to whether to distribute the required minimum distributions or accumulate them in any particular year in the trust. If creditors attack the trust, the trustee has discretion to accumulate the distributions. Although they may be subject to higher taxation because of the steeper tax rate schedule for trusts, that’s better than giving up 100% of the distribution to creditors.
With a discretionary trust, the required minimum distributions are based on the shortest life expectancy of all current and future trust beneficiaries.
Since it is possible that the trust beneficiaries could be careless or under age when the IRA is inherited, it is a good idea to put spendthrift language in the trust. In addition, the spendthrift language may also work to keep trust assets safe from creditors. An experienced attorney knowledgeable about trust drafting will be necessary to setup such a trust.
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