An individual retirement account (IRA) is generally exempt from the creditors of the original owner or participant. Even after the death of the participant, a surviving spouse can achieve the same protection from his own creditors by “rolling over” the account into his own IRA (assuming the spouse is named as beneficiary). When someone besides the spouse is named as beneficiary, however, is the inherited IRA exempt from the creditors of that beneficiary?
Maybe not. The U.S. Supreme Court ruled last week that the federal bankruptcy exemption for IRAs does not extend to inherited IRAs. In a unanimous opinion, the court reasoned that after the death of the participant (and spouse), the inherited IRA stops being “retirement funds” for federal bankruptcy purposes, because it loses any direct connection with anyone’s retirement.
Maryland law provides a separate basis for shielding an IRA and any other “retirement plan” from creditors, but no Maryland court has yet addressed whether the statute covers inherited IRAs. Courts in other states (interpreting other statutes) have gone both ways. And even if inherited IRAs are protected under Maryland law, Maryland law might not even apply. The creditor’s rights will depend on the law of the beneficiary’s state (not the participant’s state).
If protecting an IRA from the potential creditors of your children is a significant part of your estate plan, the solution may be to name a trust as the IRA’s secondary beneficiary (with the spouse usually being the primary beneficiary). The trustee can manage the inherited IRA on behalf
of the children, distributing assets to the children as appropriate, but the trust will protect the inherited IRA from the children’s creditors.
But beware: it is not always easy to continue the income tax benefits of an inherited IRA if the IRA is held in a trust. If you want to give the trustee the option of continuing the tax-deferral (for traditional IRAs) or tax-free growth (for Roth IRAs) after your death, the terms of the trust must fit within certain narrow constraints. The required terms will mesh well with some estate plans and less well with others.
With careful counseling, however, it is frequently possible to give your children both the tax benefits of an IRA and the creditor protection of a trust, all in a manner consistent with your personal estate planning goals.