There are planning options to protect inherited retirement accounts from the beneficiaries’ creditors.
At the end of the third quarter of 2014, an estimated $7.3 trillion was held in Americans’ individual retirement accounts (IRAs), almost 11 percent of all household financial assets in the United States. A recent United States Supreme Court ruling means that, without good estate planning, a significant portion of that wealth might not be protected from creditors when it passes to beneficiaries at the owners’ deaths.
In Tennessee, retirement accounts are well protected from creditors while the initial owner is living.
In federal bankruptcy. Tennessee is in the majority of states that have “opted out” of Bankruptcy Code section 522(b)(2) exemptions, meaning Tennessee bankruptcy debtors are limited to the exemptions in Bankruptcy Code section 522(b)(3). Section 522(b)(3) exempts (among other things) property exempt under state law and “retirement funds” held in a fund or account exempt under various Internal Revenue Code (IRC) sections, which include individual retirement accounts (IRAs) and qualified plans under the Employee Retirement Income Security Act (ERISA), such as 401(k) plans. Thus, in bankruptcy the initial owner’s IRAs and ERISA-qualified plan accounts are generally protected.
Outside federal bankruptcy. If a creditor pursues the retirement account of an initial owner not in bankruptcy, the creditor will be similarly out of luck. The anti-alienation provisions of ERISA section 206(d) and IRC section 401(a)(13) prohibit creditors (with some exceptions) from reaching ERISA plan accounts. In Tennessee, IRAs are exempt from any and all claims of the initial owner’s creditors (except the state of Tennessee) under Tenn. Code Ann. section 26-2-105(b).
After the initial owner dies, creditor protection for beneficiaries is uncertain.
Inherited IRAs. In Clark v. Rameker, the U. S. Supreme Court held that inherited IRAs are not “retirement funds” for purposes of Bankruptcy Code section 522(b)(3)(C), because the inheritor, unlike the original owner, (1) may not contribute to the IRA, (2) must withdraw from the IRA annually regardless of age, and (3) may withdraw the entire IRA balance at any time without penalty. Therefore, inherited IRAs will be exempt in Tennessee only if they are exempt under state law that applies inside or outside bankruptcy.
Tenn. Code Ann. section 26-2-105(b) provides the following (emphasis added):
[Except for claims under a “qualified domestic relations order,”] any funds or other assets payable to a participant or beneficiary from, or any interest of any participant or beneficiary in, a retirement plan which is qualified under §§ … 408 and 408A … of the Internal Revenue Code … are exempt from any and all claims of creditors of the participant or beneficiary, except the state of Tennessee. All records of the debtor concerning such plan and of the plan concerning the debtor’s participation in the plan, or interest in the plan, are exempt from the subpoena process.
This provision exempts traditional IRAs (IRC section 408) and Roth IRAs (IRC section 408A) from the claims of creditors of a participant or “beneficiary,” which is not defined. Does this mean an IRA beneficiary named by the initial owner? If yes, does this protection apply after the beneficiary inherits the IRA or only during the initial owner’s lifetime?
Contrast Tenn. Code Ann. section 26-2-111(1)(D), which provides that the assets of a “stock bonus, pension, profitsharing, annuity, or similar plan or contract on account of death, age or length of service” (which includes IRAs) are not exempt under that section “if the debtor may, at the debtor’s option, accelerate payment so as to receive payment in a lump sum or in periodic payments over a period of sixty (60) months or less.” Because the beneficiary of an IRA may withdraw the entire balance at any time (though required to recognize it as taxable income), an inherited IRA does not appear to be protected by that provision.
Regardless of one’s confidence in Tennessee’s state law protection of inherited IRAs, because beneficiaries move and because so few states explicitly exempt inherited IRAs, it is likely that a beneficiary’s interest in an inherited IRA will not be protected from creditors.
Inherited ERISA qualified plan accounts. The U. S. Supreme Court’s Clark rationale should mean inherited qualified plan accounts also are not “retirement accounts” for purposes of Bankruptcy Code section 522(b)(3)(C), for all the same reasons inherited IRAs are not. However, ERISA’s anti-alienation provision might continue to protect an inherited ERISA account.
There are planning options to protect inherited retirement accounts from the beneficiaries’ creditors.
Given the uncertainty of creditor protection for inherited IRAs (and perhaps inherited ERISA accounts), lawyers need to look for ways to help clients plan for their retirement account beneficiaries. The following are a few options.
A surviving spouse should consider rolling over to her own IRA any IRAs inherited from her spouse. The Supreme Court did not speak to whether an IRA inherited by a spouse and rolled over or not rolled over to his or her own IRA is an inherited IRA for purposes of Bankruptcy Code section 522(b)(3)(C). Until we get guidance, an IRA in the survivor’s name looks less like an inherited IRA than an IRA left in the deceased spouse’s name.
A non-spouse beneficiary should consider not rolling over inherited qualified plan accounts into inherited IRAs. The Clark rationale likely undermines Bankruptcy Code section 522(b)(3)(C) protection for inherited ERISA accounts, but the ERISA anti-alienation provisions might continue to offer protection.
Name a spendthrift trust as the beneficiary of the retirement account. A basic estate planning strategy is to leave inheritance to a spendthrift trust that protects trust assets from the trust beneficiaries’ creditors. The retirement account owner can name a spendthrift trust as the beneficiary of a retirement account, but doing so requires carefully navigating complex tax rules if the owner wants to preserve “stretch out” of income tax benefits.
After the death of the initial account owner, the income tax benefits of traditional and Roth retirement accounts may be extended over the life expectancy of the beneficiary if the beneficiary is a “designated beneficiary.” An individual can be a designated beneficiary, but a trust, estate, business entity or charity cannot. However, “accumulation trusts” and “conduit trusts” allow “looking through” the trust to one or more trust beneficiaries as the designated beneficiaries, with stretch out of the tax benefits.
If an “accumulation trust” satisfies four requirements for the beneficiaries of the trust to be considered designated beneficiaries, the life expectancy of the oldest current or “contingent” beneficiary (but not any mere “successor” beneficiary) will be used to determine the annual “required minimum distribution” (RMD) that must be withdrawn from the IRA by the trustee. The advantage of an accumulation trust over a conduit trust is that any amounts withdrawn from the IRA may be accumulated in the trust or distributed to or for the beneficiaries, pursuant to the trust terms. The disadvantage is that it is not always clear, without precise drafting, which beneficiaries must be considered in determining the oldest.
A “conduit trust” allows the trust to use the life expectancy of someone other than the oldest beneficiary, provided the trust requires that the annual RMD, and any other amounts withdrawn from the IRA by the trustee, be distributed from the trust to the younger beneficiary (or perhaps used for the beneficiary’s immediate benefit). Because the beneficiary will receive all RMDs (calculated using the beneficiary’s life expectancy) and no one else will receive anything distributed from the IRA during the beneficiary’s lifetime, the IRA tax benefits may be stretched out over the beneficiary’s lifetime. The disadvantage of a conduit trust compared to an accumulation trust is that RMDs must be paid outright to the beneficiary (inappropriate in some situations) and no longer will be protected from creditors.
Use a Trusteed IRA. An alternative to using a separately drafted trust is a “trusteed IRA” or “IRA trust,” offered by some financial institutions and approved under tax law as an alternative to the more common custodial IRA. The trusteed IRA, if it includes spendthrift provisions, should provide the same creditor protection as a separately drafted spendthrift trust. The advantage of a trusteed IRA is that the trust form is provided by the financial institution, so no lawyer is needed to draft the trust. The disadvantage of a trusteed IRA is that the trust form is provided by the financial institution, so the financial institution must be the trustee and the client’s lawyers might be unable to craft personal and flexible provisions. A trusteed IRA is to a lawyer-drafted spendthrift trust what a Uniform Transfers to Minors Act custodial account is to a trust: cheaper to create, sufficient in some situations, and deficient in others.
- “Retirement Assets Total $24.2 Trillion in Third Quarter 2014,” Investment Company Institute (Feb. 26, 2:05 PM), http://www.ici.org/research/stats/retirement.
- Tenn. Code Ann. § 26-2-112.
- The amount of an IRA protected in bankruptcy is subject to a generous dollar limit under 522(n). Because a named beneficiary of an IRA or qualified plan account (other than a spouse for certain purposes) has no rights in the account until the owner dies, the account cannot be reached by the beneficiary’s creditors while the initial owner is living.
- 29 U.S.C. § 1056(d)(1), 26 U.S.C. § 401(a)(13). To the extent that Tenn. Code Ann. Section 26-2-111 (1)(D) addresses ERISA accounts, it is preempted by ERISA. In re Seller, 107 B.R. 152 (Bankr. E.D. Tenn 1989); see also ERISA § 514(a), 29 U.S.C. § 1144(a).
- Clark v. Rameker, 134 S.Ct. 2242 (2014).
- At least six states have explicitly exempted inherited IRAs from creditor claims. See Fla. Stat. § 222.21; Ohio Rev. Code § 2329.66; Mo. Rev. Stat. § 513.430; Alaska Stat. § 09.38.017; Tex. Prob. Code § 42.0021; N.C. Gen. Stat. § 1C-1601. In states that have not, many court cases, applying rationale similar to that in Clark, have found that inherited IRAs do not afford the same creditor protection as IRAs held by the initial owner.
- Tenn. Code Ann. § 26-2-111(1)(D).
- The issue is moot for some qualified plans, which require a lump sum or relatively short-term payout to beneficiaries. Any amounts distributed from a retirement account to an individual lose whatever creditor protection the account offered.
- IRC § 401(a)(9). Traditional IRAs allow pre-tax (tax-deductible) contributions and deferral of all income taxation until assets are withdrawn from the account, at which time the entire withdrawal is taxable. Roth IRAs are funded by after-tax (nondeductible) contributions, but all growth within the IRA is tax-free. Generally, the longer value can be left in the IRA with compounding growth, the greater the income tax benefits of the IRA. The same advantages are available under federal law for traditional and Roth 401(k) accounts, but, as noted above, some plans do not allow beneficiary stretch out. If the IRA owner dies before her required beginning date (April 1 of the calendar year following the calendar year of death) (RBD) and there is no designated beneficiary, then the entire balance of the IRA must be distributed no later than the end of the fifth calendar year after the year of the owner’s death. If the IRA owner dies before her RBD and there is a designated beneficiary, RMDs are based on the beneficiary’s life expectancy (all life expectancies determined under IRS tables). If the IRA owner dies on or after her RBD and there is no designated beneficiary, RMDs are based on the owner’s life expectancy (without regard to death). If the IRA owner dies on or after her RBD and there is a designated beneficiary, RMDs are based on longer of the owner’s life expectancy (without regard to death) and the beneficiary’s life expectancy.
- To avoid the owner’s estate being deemed a beneficiary of a revocable trust to which a retirement account is payable, the trust should include a provision prohibiting using retirement assets to pay any estate obligations (taxes, debts, expenses) after Sept. 30 of the year following the year of death (the date as of which the designated beneficiary determination is made).
- (1) The trust is valid under state law; (2) the trust is irrevocable or will become irrevocable upon the death of the IRA owner; (3) the trust beneficiaries who may benefit from the IRA are identifiable from the IRA beneficiary designation or the trust instrument; and (4) a copy of the trust or specified alternate documentation is given to the IRA plan administrator by Oct. 31 of the year following the year of the owner’s death. Treas. Reg. § 1.409(a)(9)-4(a)(5)(b).
- Treas. Reg. § 1.409(a)(9)-5, A-7.