Inherited IRAs Have Become More Vulnerable – June 2014

Jul 14, 2014 | by Franck Cushner, CFP®

For years, IRAs have been a primary way for individuals to save for retirement and defer taxes. As of the end of 2013, over 46 million households owned some type of IRA, with over $6.52 trillion in total assets.

Since the initial introduction of Traditional IRAs in 1974, IRAs have metamorphosized into various account types, including SEP IRAs, SAR-SEP IRAs, SIMPLE IRAs, and after-tax IRAs (Roth IRAs). As these additional IRA types were introduced, additional contributions allowed for even greater growth of overall IRA assets.

After years of saving and prudent investing, some IRA owners are reaching retirement with no need to access their accounts (except for Required Minimum Distributions) and are increasingly being left to beneficiaries, such as children and even non-relatives. Spousal IRAs are still popular, yet more and more IRA owners are leaving their IRA assets to their children, rather than to their spouses.

For married IRA owners, the primary beneficiary is usually the spouse, however, for unmarried account owners, their children and non-relatives are the beneficiaries. When an IRA owner dies, the assets of the IRA are either distributed in cash or “rolled over” to an Inherited IRA in the name of the beneficiary. 

For years, the benefits of an Inherited IRA have been tax deferred growth and, protection from creditors, just as a Traditional IRA. A significant change to the status of Inherited IRA assets changed in June 2014 when the Supreme Court ruled that Inherited IRA assets are subject to creditors and not deemed retirement accounts. 

Retirement accounts, such as Pension Plans and Traditional IRAs have been afforded protection from creditors due to their retirement status, whereas retirement assets provide for the well being of retirees. Bankruptcy code section 522(b) (3) (c) excludes retirement funds from a bankruptcy to the extent that those funds are exempt from taxation. 

The U.S. Supreme Court ruled that funds from an Inherited IRA were not retirement funds for the following reasons:

-Inherited IRA owners may not make additional contributions to the account

-Owners must withdraw funds from their accounts, regardless of how many years from retirement they are

-Owners are not subject to any age related penalties for withdrawals

 

The Supreme Court ruling went on to say that “funds held in Inherited IRAs accordingly constitute a pot of money that can be freely used for current consumption, not funds objectively set aside for one’s retirement”.

The significance of this ruling affects over 40% of all households, whose $6.52 trillion in IRA accounts may eventually be going into Inherited IRA accounts.

With a growing number of IRA beneficiaries suffering from financial constraints, the concern that has now arisen is whether or not assets held in an Inherited IRA are safe from creditors.

Some estate planning specialists are suggesting the assets fall into a “Spend-Thrift Trust,” which qualifies as a “see through trust” to enable continued tax deferral.

Everyone’s circumstances are unique, so a diligent and objective review is suggested before making any modifications to existing IRAs.

Sources:          U.S. Supreme Court, IRS, ICI

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