Have you tried to do your own mini-estate plan and named your children or other loved ones as beneficiaries of your IRA? If you did, you may end up giving that IRA to the beneficiaries’ creditors.
Under both Federal and State statutes, retirement funds are given special treatment in the event that a debtor files for bankruptcy. Retirement funds are excludable from the debtor’s bankruptcy estate and exempt from claims of creditors. Retirement funds are protected for the benefit of the debtor.
If you file for bankruptcy, you get to keep your retirement funds held in your IRAs and qualified retirement plans such as 401(k), 403(b) and 457 plans. Your creditors cannot touch them.
If you name a child or other loved one as a beneficiary of your IRA, after your death, he or she must receive minimum distributions from your IRA each year. The beneficiary could take out more without penalty.
What if that child or other loved one named as a beneficiary or your IRA files for bankruptcy? Is that inherited IRA considered “retirement funds” under the Bankruptcy Code and protected from creditors?
As of June 12, 2014, the answer is a resounding NO! The United States Supreme Court in CLARK v. RAMEKER ruled that inherited IRAs are not “retirement funds” that are exempt under the Bankruptcy Code. The ruling applied to all inherited IRAs, including spousal inherited IRAs, but not to spousal rollover IRAs or debtors using the state bankruptcy exemptions.
Since inherited IRAs are not exempt retirement funds, your children or other loved ones could lose their entire inheritance to bankruptcy creditors. Is there something that you can do to protect your children or other loved ones from this situation? Absolutely! Don’t name your children or other loved ones as beneficiaries of your IRAs. Name your trust.
I am often questioned by financial advisors, banks and mutual fund companies if I meant to name a trust as primary beneficiary of retirement accounts. Yes, I meant to do that. Even though the IRS issued final regulations regarding retirement account minimum distribution rules in 2002, there are still many misconceptions in the financial advisor community regarding the naming of a trust as the beneficiary of retirement accounts:
The general rule is that when your trust is named as your retirement plan beneficiary, the distributions must be made within five years after your death if death occurs before your required beginning date which is generally age 70½. If your death occurs after your required beginning date, then distributions to your trust must be made over your life expectancy and not over your intended beneficiary’s life expectancy.
There is an exception to the general rule called a designated beneficiary test. If your trust contains terms that assure that it meets the requirements of the designated beneficiary test, it allows your trustee to ignore the trust and look through to find and use the life expectancy of one of your trust beneficiaries when making distributions. This is just as if your trust beneficiary had been named directly a beneficiary of your IRA. The stretch out IRA concept still remains available to your trust and your beneficiaries.
To meet the designated beneficiary test, the trust must a) be valid under state law, b) have individual beneficiaries, c) have identifiable beneficiaries, d) have a copy of the trust delivered to the plan administrator, and e) be irrevocable upon death. We make sure that trusts we draft are specifically designed to receive retirement plan distributions and meet the designated beneficiary test.
When we prepare a trust-based estate plan, we also prepare the beneficiary designation forms for the retirement plans to ensure that they track with the instructions in the trust. Many employer-based plans and all IRAs allow beneficiaries after the death of the participant to “stretch out” or distribute the retirement benefit over the lifetime of the beneficiary.
In these cases, we name your trust as your primary beneficiary of these retirement accounts. We name the children or other loved ones as your contingent beneficiaries. This gives us the most options after your death.
In addition, your trust should have provisions which provide benefits to your children or other loved ones through lifetime trusts. This is one of the best ways to provide for your children or other loved ones and to protect them not only from themselves, but from creditors, including bankruptcy creditors.
With lifetime trusts, your children or other loved ones would have access to their inheritance for their needs. However, if a child or other loved one has a catastrophic creditor as a result of a car accident, lawsuit, bankruptcy or otherwise, the trust assets would be protected from that creditor.
Not every trust out there qualifies as a designated beneficiary. Before you name your trust as a beneficiary of your retirement account, have your trust reviewed by a knowledgeable legal specialist to ensure that it qualifies as a designated beneficiary. If you name your trust as a primary beneficiary and it does not qualify as a designated beneficiary, you will end up with the negative tax consequences of the five year payout. With proper planning and proper drafting, you can maximize the protections and benefits to your family and minimize their overall tax burden.
You may say the heck with it, I’m dead, I don’t care what the kids or other loved ones do with their inheritance. In those situations, you could just leave it outright to the kids or other loved ones. Just let them or their creditors spend it all.
The thing is that it is your money. You can do with it whatever you please. There is no right or wrong way of leaving assets to your kid or other loved ones. If you want to add protections, you can add protections. If you want to let them blow it, let them blow it. It is all up to you.
By: Matthew Wallace, CPA, JD
Published edited June 22, 2014 in The Times Herald newspaper, Port Huron, Michigan as: Inherited IRAs now reachable by creditors