Everyone knows that IRAs are a great way to save for retirement, but the potential to protect against creditors is another valuable aspect of these accounts. Is the same protection extended to beneficiaries? This article from Forbes, “Estate Planning Tip: Creditor Protection for IRAs & Beneficiaries,” explains in detail how these rules apply to various bankruptcy situations and the issues to consider when naming your IRA beneficiaries.
Bankruptcy. Similar to the protection offered to pensions, 401(k)s and Social Security benefits, IRAs can be protected from creditors in bankruptcy. If you declare bankruptcy, your IRA assets will typically be safeguarded and can’t be taken. However, this doesn’t extend to other types of judgments, civil lawsuits, or IRS levies. State laws will vary, but your IRA assets may be protected from other creditors. There is a $1 million inflation-adjusted limit that applies to federal bankruptcy protection rules for the aggregate value of Contributory and Roth IRAs (with inflation, the limit is $1,283,025 as of April 1, 2016). Assets rolled over to an IRA from a qualified plan, like a 401(k), aren’t subject to the same dollar limits and can be fully protected.
Beneficiaries Protection. A big benefit to IRAs is the simplicity in selecting a beneficiary to receive the money when you die. This can be a great estate planning tool because these assets are not subject to probate and pass directly to the beneficiary. Make sure that your beneficiary designations line up with your overall estate planning goals. However, beneficiaries of IRAs are not always given the same creditor protection as the original account owner, so you need to consider this when selecting your IRA beneficiary.
An inherited IRA for a non-spouse beneficiary is no longer automatically protected from creditor’s claims when the beneficiary files for bankruptcy. When the owner dies, and the non-spouse beneficiary takes ownership of the account, the assets are no longer deemed retirement funds, and can be seized in bankruptcy. This only applies to non-spouse beneficiaries because a spouse can roll over inherited IRA assets into his or her own account. When this transfer occurs to a surviving spouse, the assets are once again protected. However, a non-spouse beneficiary can’t comingle inherited IRA assets with their own retirement assets. Check your state laws on the degree of protection over non-spousal inherited retirement funds.
Children as beneficiaries. Many parents opt for their children to be beneficiaries of their IRA accounts. This can be an issue if the children have financial issues or face debt collectors. You can get around this be creating a conduit trust, and by listing the trust as beneficiary of the IRA and not the child. As a result, an inherited IRA payable to a trust can be protected from the child’s creditors while still allowing the child to benefit from the inheritance. The IRA’s required minimum distributions are calculated on the trust beneficiary’s life expectancy, and income is taxed at the beneficiary’s tax rate. Since the assets aren’t legally owned by the beneficiary, they’re protected from creditors in most instances. However, keep in mind that once the income is paid out to the beneficiary, that income isn’t protected.
Like so many other estate plans, IRA beneficiaries should be reviewed regularly. Your own goals may change, and your beneficiaries will also experience changes in their lives. If a child is going through a divorce, for instance, you may want to work with a qualified estate planning attorney to find a way to protect your legacy and your child. Your state’s laws on creditor protection may change, as may tax laws. A regular review with an estate planning attorney is a worthwhile investment.
Reference: Forbes (December 9, 2016) “Estate Planning Tip: Creditor Protection for IRAs & Beneficiaries”