Individual Retirement Accounts are perhaps your most safeguarded and income tax-efficient asset: are deducted from your adjusted gross income for income tax purposes, principal grows tax deferred, and the account is protected from just about any creditor other than a spouse (even in bankruptcy and against lawsuits). At least that was the case until 2014.
When a person passes away with an IRA, any beneficiary may take all funds out of the existing IRA as long as they do so within five years. This means all IRA assets are distributed quickly, negating long-term tax deferral and assessing income tax payments on the large distributions. And all funds are now out of the IRA, so they are no longer protected.
A spouse may transfer the deceased spouse’s funds to her own IRA. This continues tax deferral and asset protection. This is the best rollover option, but remember that it is ONLY available for a spouse.
INHERITED IRAs
Anyone other than a spouse may transfer funds to an “Inherited IRA.” This does continue income tax deferral, often at a slightly accelerated rate, which is a good thing. HOWEVER, in 2014 the US Supreme Court ruled in Clark v. Rameker that an Inherited IRA is NOT protected from a beneficiary’s creditors during a bankruptcy.
This could mean that any child who inherits an IRA who is going through bankruptcy, a divorce, receiving Medicaid benefits, and the like may have to empty out the Inherited IRA to pay their creditors AND pay the associated income taxes. Considering the sheer size of assets held in IRAs, and the fact that parents are told to live on non-IRA assets first to let IRAs continue deferral, beneficiaries may face this painful double sting to pay off their creditors.
There are still a lot of final decisions to be made as to which circumstances Inherited IRAs will face creditor challenges, but experience would say that if the Supreme Court will allow a private entity, such as a bank, to invade Inherited IRA assets, they would almost certainly allow the IRS or Medicaid to do the same.
Stay in touch with your Estate Planning Attorney to keep in the loop.
Q for You: When was the last time you updated your Beneficiary Designation Form for your retirement plan?
