Inherited IRAs Not Protected From Beneficiary’s Creditors

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August 30, 2011

In a recent decision, the United States Bankruptcy Court for the Western District of Wisconsin ruled that inherited IRAs are not protected from a beneficiary’s creditors. Bankruptcy courts in different parts of the country have come to the same conclusion, while others have come to a different conclusion. These cases may stand as they are or the United States Supreme Court may reconcile the different opinions. For the time being, it is important for IRA owners in Wisconsin to understand the rules that will apply if a creditor seeks to recover from the beneficiary of an inherited IRA.

In the case In re Clark, Case No. 10-18035, decided on May 10, 2011, the beneficiary of an inherited IRA filed for bankruptcy. The beneficiary attempted to claim the inherited IRA as an exempt (or protected) asset under both federal and Wisconsin bankruptcy exemptions. The bankruptcy court concluded that while IRAs in the hands of their owners are exempt assets and therefore are protected in bankruptcy actions, inherited IRAs do not enjoy that same protection. Consequently, the beneficiary of the inherited IRA was required to liquidate the IRA in order to pay her creditors.

IRA owners, such as parents or grandparents, who want to provide asset protection for an intended beneficiary of an inherited IRA should consider establishing and naming a specially designed trust as the actual beneficiary of the inherited IRA. Normally, a trust is not a good choice as a beneficiary of an IRA because the entire IRA is subject to accelerated income tax at the death of the owner. However, if the trust is properly drafted, the IRS will “look through” the trust to the individual who is named as the trust beneficiary, or the oldest individual if more than one is named, as if the IRA owner had named the person directly as the outright beneficiary of the IRA. This allows the receipt of taxable income from the IRA to be “stretched-out” over the individual’s life expectancy, which provides a more favorable income tax result.
In addition to “stretching out” the taxable income from the inherited IRA (and perhaps more importantly), this kind of specially designed trust can provide asset protection to the individual trust beneficiary under Wisconsin trust law. Thus, the assets of the trust (i.e., the distributions received from the inherited IRA) can be protected in the event the trust beneficiary files for bankruptcy, is divorced, has liability for personal guarantees of business loans, has uninsured health care costs, or has uninsured long-term care and nursing home costs.

If you would like to know more about asset protection planning within your estate plan, please contact any of the attorneys in the Trusts & Estates Practice Group of Ruder Ware.

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