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Supreme Court Ponders Changing the Rules on Nonspousal Inherited IRAs

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The rules of the game may soon be changing for some clients who have planned to use traditional IRAs as estate planning vehicles, pending the Supreme Court’s decision in a case that could expose all nonspousal inherited IRA funds to creditor claims in bankruptcy.

Many clients have stashed most—if not all—of their savings in IRAs so that these accounts are likely to function as wealth planning vehicles regardless of whether this was the client’s intention. The end result: whether your clients know it or not, this Supreme Court decision is one that could substantially impact the value of their legacies and their prospective estate planning choices.

Inherited IRAs on Trial

Traditional and Roth IRAs are typically exempt from bankruptcy claims up to an inflation-adjusted $1 million limit (in 2014, the amount is $1,245,475). What many clients do not realize is that this exemption does not always apply to an IRA that is inherited by a nonspouse beneficiary because of a disagreement among the courts over whether inherited IRA funds constitute retirement assets that deserve this protection.

While in some jurisdictions (the Eighth Circuit, for example), inherited IRAs are exempt from bankruptcy claims based on the premise that the funds are retirement funds contained in otherwise tax-exempt vehicles, other courts have held that inherited IRAs lack the requisite retirement purpose. The rationale behind this line of decisions (most prominently found in the Seventh Circuit) is that inherited IRAs are subject to an entirely different set of rules than IRAs held by their original owners.

Importantly, while a penalty is imposed on any noninherited IRA funds that are withdrawn by the owner prior to a certain age, inherited IRA assets are liquid assets that can be accessed by the beneficiary at any time and without penalty. Further, the rules actually require that the inherited IRA funds be withdrawn within a relatively short time frame (either within five years or over the beneficiary’s life expectancy) set without regard to the typical retirement age.

This split among the circuits prompted the Supreme Court’s recent review of the issue, which is expected to generate a decision sometime in June.

Planning Tools for the Future

For clients with heirs that may have unstable financial histories or are engaged in risky business ventures, the potential impact of this ruling is clear, and if the Supreme Court agrees with the Seventh Circuit rationale, a new planning technique may be necessary in order to maximize the benefits of the inherited IRA.

In some cases, it may be beneficial to name a trust as the client’s IRA beneficiary and the actual heir as beneficiary of the trust. This strategy will protect the inherited IRA funds from creditors of the actual heir as long as the trust is drafted appropriately. Use of a trust can also control the heir’s ability to withdraw funds from the inherited IRA—both as to timing and amount of withdrawals—so as to ensure that the tax benefits of the IRA are stretched over the maximum possible time frame.

The trust shielding the assets must be irrevocable, which restricts the use of the funds even though creditor protection may not be an issue. Further, in order to allow a client’s heirs to stretch out the tax-deferred withdrawals from the inherited IRA, the trust must qualify as a see-through trust. This means that the beneficiaries must all be individuals, so that the IRS “looks through” the trust to the individual beneficiaries as though they were the direct beneficiaries. Essentially, this rule exists because beneficiaries who are not individuals (i.e., non-natural “persons” such as a corporation or estate) do not have life expectancies over which the account value can be stretched.


In many cases, the Supreme Court’s decision could lead clients to rethink strategic plans to leave IRA assets to their children, but the large number of clients who hold substantial IRA assets for retirement purposes means that this is a discussion that should be had with all clients whose retirement assets could pass to a nonspouse beneficiary.

Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.

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