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April 14, 2014 at 01:01 PM
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Importantly, while a penalty is imposed on any noninherited IRA funds that are withdrawn by the owner prior to a certain age, inherited IRA assets are liquid assets that can be accessed by the beneficiary at any time and without penalty. Further, the rules actually require that the inherited IRA funds be withdrawn within a relatively short time frame (either within five years or over the beneficiary’s life expectancy) set without regard to the typical retirement age.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.
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