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Protecting Your Children's Inherited IRA from Creditors

Protecting Your Children's Inherited IRA from Creditors

Much of the wealth currently owned by baby boomers exists in company sponsored retirement plans, such as a 401(k), 403(b) or 457 plan account or in Individual Retirement Accounts (“IRA”s).  Those trillions of dollars of assets are poised to be involved in our planet’s largest inter-generational wealth transfer in history.  More often than not, it is a couple’s children that will eventually inherit from their parents.  But first, the average baby boomer American worker likely lists their spouse as their “primary” beneficiary to receive all of their assets should they decease. 

After the first spouse passes away, the surviving spouse and sole primary beneficiary, will usually rollover that retirement plan money into an IRA that they own, and enjoy the same creditor protection their spouse enjoyed in their lifetime.  The spouse is allowed to treat these retirement funds as if they were their own using a Spousal transfer.  For that, the surviving spouse usually names their kids as their primary beneficiaries.  Unlike their parent, after the second parent passes away, the kids have no choice but to open what is called an “Inherited IRA”.  An Inherited IRA is different for a number of reasons, including the requirement that the beneficiary start to take withdrawals no matter how close they are to retirement.  And unlike a Spousal IRA, the US Supreme Court decided in 2014 in Clark v. Rameker that Inherited IRAs are fair game for creditors seeking to recover from a debtor in bankruptcy. 

An argument can be made that this makes some sense from a public policy standpoint:  couples that have saved for their retirement should be protected to a degree so that their nest egg is there for them should they fall on hard times and have to file bankruptcy.  Kids that were not involved in the working and the saving of the money, and essentially receive assets they had no hand in creating, arguably should not have a free pass protecting those assets should they enter into bankruptcy.  After all these funds were not saved by them to be their nest egg in their retirement. 

So what is a company sponsored retirement account owner or an IRA owner to do to protect their kids or other non-spouse beneficiaries from creditors (and/or from themselves)?  Instead of writing them in as beneficiary, naming a well drafted trust prepared by a competent estate planning attorney would do the job.  In that case, the retirement plan assets are protected from creditors because they are owned by the trust, not the the kid or other person who is named as the trust’s beneficiary.  Properly drafted, the trust would name a trustee that is a person other than the child that is the trust’s beneficiary. 

The trust maker must also decide how they want the retirement plan money to flow to their beneficiary.  In “conduit” trusts, the trustee passes IRA distributions immediately along to the trust beneficiary.  In that case, though, the distributions become fair game for creditors because they are then in the hands of the debtor, i.e. are no longer are in the trust.  In “accumulation trusts”, on the other hand, the trustee is not required to distribute IRA funds to trust beneficiaries, and instead has discretion over whether to do so.  The biggest drawback to an accumulation trust is the level of taxation that quickly increases on earnings on assets within the trust.  The biggest reason to use this form of trust is when your beneficiary has substance abuse issues, is in a high-risk profession, or otherwise has problems managing their money and is likely to be sued in bankruptcy. 

Consult your estate planning attorney to discuss this matter, and please feel free also to reach out to your GBB advisor or the author of this article to discuss your family’s needs. Give GBB a call at (916) 924-7527 or complete our contact form.

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