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Court Finds Inherited IRAs Are Not Exempt Under Bankruptcy Code

Under current federal bankruptcy code, an exemption applies for certain tax-qualified retirement funds and accounts including assets such as many 401Ks, annuity plans, IRAs, qualified governmental plans, deferred compensation plans (state and local) and some tax-exempt organizations.

However, a Bankruptcy Court has concluded that, unlike a debtor's own traditional individual retirement account (IRA), a debtor's inherited IRA is not an exempt asset of her bankruptcy estate under Bankruptcy Code §522(d)(12).  This ruling underscores the importance of having your personal finances and estate plan working together, including coordinating the beneficiary designation of tax-qualified retirement accounts, annuities and IRAs with your estate plan. 

The impact of this Bankruptcy Court’s ruling was that the debtor’s interest in the IRA which he inherited from his parent was fully accessible (and therefore taken) by his creditor.  This ruling is consistent with a number of court cases in various states which have held that a debtor’s inherited IRA was not protected from the debtor’s creditors.

If your estate plan is structured to help protect your heirs’ inheritance from their creditors, and if part of your assets include tax-qualified retirement accounts, annuities and IRAs, then you must take this Bankruptcy Court’s ruling into account when structuring your estate plan, by creating a standalone IRA Trust to be the beneficiary of your tax-qualified retirement accounts, annuities and IRAs.

Note these other important conditions:

  • If an IRA owner designates his spouse as beneficiary of his IRA and dies before the account is exhausted, the surviving spouse may roll over the decedent's IRA into the spouse's own IRA, or elect to treat the decedent's IRA as the spouse's own IRA.   This avoids the impact of the ruling noted above.
  • A designated non-spouse beneficiary can't treat an inherited IRA as his own, but can make trustee-to-trustee transfers of the inherited amount to another IRA if the ownership of the new IRA is set up in the same way as the ownership of the old IRA, that is, in the name of the decedent for the benefit of the IRA beneficiary.  Thus, pursuant to the ruling above, this would subject the inherited IRA to the creditors of the designated non-spouse beneficiary.  In order to protect the IRA from the beneficiary’s creditors, the best approach is to create a standalone IRA Trust to be the beneficiary of the IRA.
  • If the account owner dies before his required beginning date or RBD (which, for IRA owners, is Apr. 1st of the year following the year in which the owner attains age 70 1/2), the entire balance in a participant's plan account must be:
    • distributed within five years after the account owner's death; or
    • distributed to (or for the benefit of) the designated beneficiary, over the beneficiary's life or over a period that doesn't extend beyond his life expectancy.
  • Slightly more liberal rules apply if the account owner dies after his RBD.
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