After High Court Ruling, How to Protect Clients

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A recent high court ruling signals change for any client planning to pass along an IRA to heirs - and perhaps for some who have inherited IRAs themselves.

The U.S. Supreme Court ruled unanimously in June that under federal law inherited IRAs are not protected in bankruptcy.

Although this ruling does not affect your clients’ own IRAs - those retirement funds are still protected in bankruptcy — it may cause problems when their children inherit the IRA. Your clients should know that the IRAs they built could be lost if their children have financial problems.

In the underlying case - Clark et ux. v. Rameker, Trustee - Ruth Heffron named her daughter, Heidi Heffron-Clark, as her IRA beneficiary. After Heffron died in 2001, Heffron-Clark set up an inherited IRA and began receiving distributions.

At the time, the inherited IRA was worth just over $450,000. By 2010, when she and her husband filed for bankruptcy, the inherited IRA was worth about $300,000.

As part of the bankruptcy proceedings, Heffron-Clark claimed the inherited IRA as an exempt asset consisting of “retirement funds” — as defined by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. That law, which was intended to make filing for bankruptcy less appealing, had a silver lining for retirement account owners: It afforded a great deal of bankruptcy protection to retirement funds, providing a cumulative $1 million inflation-adjusted exemption (now up to $1,245,475) for IRAs and Roth IRAs and an unlimited exemption for employer-sponsored plans.


But Heffron-Clark’s creditors questioned whether “retirement funds” included inherited IRAs, since the IRA was her mother’s retirement account. In deciding the Heffron-Clark case, the primary issue before the Supreme Court was whether an inherited IRA is a retirement account.

The main argument from Heffron-Clark’s attorneys went something like this: If someone owns a house and that house is left to a child, no one would argue that it’s no longer a house — so why should an IRA be any different? If it was a retirement account for the original owner, why should its character change because the owner dies?

Her creditors, of course, saw it differently - and, ultimately, so did the justices. The Supreme Court identified several characteristics of inherited IRAs that were not characteristics of a retirement account:

  • Beneficiaries cannot add money to inherited IRAs as owners can to their own accounts.
  • Beneficiaries of inherited IRAs must generally begin to take required minimum distributions in the year after they inherit the account, even if they are far away from retirement.
  • Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a penalty.

Based on those differences, the Supreme Court decided that inherited IRAs do not contain “retirement funds” as defined by federal bankruptcy law — and, as a result, are not protected from creditors. Put another way, at the moment an IRA owner dies and the IRA funds pass to a beneficiary, their character changes from that of retirement funds to nonretirement funds.
The Supreme Court also seems to have been swayed by the overall implications of protecting inherited IRAs for beneficiaries. The justices said that protecting such funds would amount to a “free pass” for IRA beneficiaries — giving them little incentive to use these accounts to pay their creditors instead of, say, using the money for “a vacation home or sports car.”


Since the court’s decision was handed down, experts have been questioning just how wide a net the Heffron-Clark decision casts. Does it affect spouses who inherit an IRA? The Supreme Court’s decision did not explicitly say one way or another.

Many experts believe that the Heffron-Clark decision will not apply to spouses who inherit an IRA. There are a number of special rules for spousal beneficiaries under the Tax Code that create a clear distinction between spouse and nonspouse beneficiaries.

Another possibility, however, is that a spouse inheriting an IRA will be unable to claim an exemption for it. If so, it will make no difference from a bankruptcy perspective whether the client keeps the account as an inherited IRA or does a spousal rollover. Either way, the funds could be considered part of the surviving spouse’s bankruptcy estate.

Or perhaps spousal beneficiaries who complete a spousal rollover or treat the inherited IRA as their own could claim an exemption, but those who maintain the accounts as inherited IRAs will not. Such situations could be complicated by the timing of the surviving spouse’s insolvency, and would have clear implications for planners.

At some point it seems likely that an aggressive creditor or bankruptcy trustee will test the issue and force it to be decided by the courts. Until then, advisors may wish to treat spousal and nonspousal beneficiaries the same way. The question now is how to keep clients’ hard-earned money safe if their heirs run into trouble with creditors.

For some, state law may provide protection. While the Supreme Court found that inherited IRAs are not protected by federal law, the ruling doesn’t prevent states from offering bankruptcy protection to inherited IRAs. Indeed, seven states — Alaska, Arizona, Florida, Missouri, North Carolina, Ohio and Texas - have adopted laws expressly exempting inherited IRAs under bankruptcy statutes.

For clients in states with no inherited IRA protection, there are other approaches that advisors might use. Perhaps the most obvious, especially in situations where bankruptcy or general creditor protection for your clients’ beneficiaries is a major concern, is to name a trust as the IRA beneficiary.

If a trust is drafted properly, it can help shield assets from the trust beneficiaries’ creditors, while still allowing the trust to stretch distributions from the inherited IRA over the life expectancy of the oldest trust beneficiary.
increased tax burden?

There are some potential drawbacks to consider, though. Some are related to issues of complexity and accounting and trustee fees. Advisors should also be mindful of an increased tax burden because of the compressed trust tax brackets - although a Roth IRA conversion during the owner’s lifetime could help alleviate the trust tax issues, as could allowing the trustee to pass IRA distributions through the trust and on to beneficiaries.

If your clients do not need all or a portion of their IRA for retirement purposes, another option is to use some of the IRA money to buy life insurance and leave the insurance to a trust. Life insurance is, for a host of reasons, a much more trust-friendly asset than an IRA or Roth IRA, and life insurance proceeds are generally tax free - reducing the impact of the trust tax rates.

In light of this landmark ruling, advisors should start having conversations about how to protect IRA assets for heirs — especially with clients who want to make sure their hard-earned money is not lost to their children’s bad financial decisions.

Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer and an IRA distribution expert, professional speaker and author of many books on IRAs. Follow him on Twitter at @theslottreport.

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