Since Congress amended the U.S. bankruptcy code in 2005, retirement assets like IRA accounts, pensions and 401(k) plans have generally been protected from creditors in the event of personal insolvency. However, a recent court ruling has drawn a clear and stark distinction regarding inherited IRAs: they don't count as retirement assets.
Two weeks ago, the U.S. Supreme Court unanimously held that IRA accounts passed along to non-spousal beneficiaries are to be treated like any other asset when the bill collector comes knocking. That means inherited IRAs are fair game for distribution to creditors in cases of personal bankruptcy. While not altogether surprising, the decision suggests important considerations for holders of large retirement accounts who plan to pass money along to the next generation.
As most people know, Individual Retirement Accounts (IRAs) are tax-sheltered vehicles through which workers may save and invest for their eventual retirement. They also serve as conduits into which 401(k) and some pension plan savings may be rolled over to preserve tax-deferred status. One feature of an IRA account is the provision for naming one or more beneficiaries to receive the funds upon the demise of the primary account holder.
If the beneficiary is a spouse, the account may be transferred directly into the spouse's own name or rolled into her own IRA. However, any recipient other than a spouse receives only limited tax deferral and must complete the process of withdrawing the funds and paying taxes within a specified time frame. This is the key distinction which the court highlighted.
Given that the account cannot be added to, and since no penalty for early withdrawal applies, the court concluded that the inherited IRA does not possess the characteristics that distinguish a true retirement account arrangement and is therefore not protected from creditors in bankruptcy. In her majority opinion, Justice Sonia Sotomayor observed that "nothing about the inherited IRA's legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete."
While this decision should not discourage savers from taking full advantage of IRA accounts for retirement asset accumulation, it does highlight one possible pitfall for holders of large accounts with non-spousal heirs that might conceivably be prone to profligacy or to assume significant financial risks. In this case, the designation of a properly drafted "spendthrift trust" as beneficiary could retain protection from creditors and define the terms of the asset disposition as well.
A few states have adopted their own statutes protecting inherited IRAs in bankruptcy (although neither Tennessee nor Georgia is among them). Nevertheless, it is hard to see how these accounts are substantially different from any other inherited asset and why they should be treated differently.
As more members of the baby boom generation accumulate significant balances in their retirement accounts, the issue will gain in significance. A modicum of consideration and planning ahead of time might prevent some of your hard-earned savings from washing away a generation hence.
Christopher A. Hopkins, CFA, is a vice president at Barnett and Co. Investment Counsel.