Estate Planning Tip: Creditor Protection for IRAs & Beneficiaries

Individual Retirement Accounts (IRAs) are great tax-deferred savings vehicles, but tax deferral isn’t the only benefit IRAs offer. One potential benefit is creditor protection in the event of a bankruptcy. But when you pass away, are your beneficiaries protected?

Investors should know how their assets can be better protected in the event of bankruptcy or lawsuits. Thankfully, the Supreme Court has helped clear up this issue in recent years. This article will outline some of the issues facing IRA investors and their beneficiaries when it comes to bankruptcy and things they should consider when naming an IRA beneficiary.

Bankruptcy & Retirement Accounts

According to the Tax Adviser, like protection offered to pensions, 401(k)s and Social Security benefits, IRAs can be protected from creditors in bankruptcy proceedings. This means that if you declare bankruptcy, your IRA assets are usually safeguarded and cannot be seized. Note that this protection does not extend to other types of judgments, civil lawsuits, or IRS levies. Depending on state law, your IRA assets may be protected from other creditors, but the rules vary.

A $1 million inflation-adjusted limit applies to the federal bankruptcy protection rules for the aggregate value of Contributory and Roth IRAs. Accounting for inflation, this limit is $1,283,025 as of April 1, 2016, per Ed Slott & Co.

Assets that have been rolled over to an IRA from a qualified plan, such as a 401(k), are not subject to the same dollar limits and can be fully protected.

Are Beneficiaries Protected?

A huge benefit to IRAs is the simplicity in selecting a beneficiary (or beneficiaries) who will receive the money once you pass. This is a great estate planning tool, as these assets will be kept out of probate and pass directly to the beneficiary. Lauren Jenkins, an attorney at Offit Kurman in Vienna, VA, explains to her clients that “estate planning is more than just a set of documents. It includes ensuring that your beneficiary designations are in accord with your overall estate planning goals.”

This can take careful planning. The good news is that even if you do not have a will or other estate documents, you can still control who receives your retirement assets upon your death.

Beneficiaries of IRAs, however, are not always afforded the same creditor protection as the original account owner, and this is one factor to consider when determining who your IRA beneficiary should be. The United States Supreme Court has ruled that an inherited IRA for a non-spouse beneficiary no longer is protected from creditor’s claims when the beneficiary files for bankruptcy. The rationale is that once the owner dies and the non-spouse beneficiary takes ownership of the account, the assets are no longer considered retirement funds, and can thus be seized in bankruptcy proceedings.

The reason this only applies to non-spouse beneficiaries is because a spouse is able to roll over inherited IRA assets into their own account. When this type of transfer occurs, the assets are once again protected. A non-spouse beneficiary, however, cannot comingle inherited IRA assets with their own retirement assets.

Are Beneficiaries Out of Luck?

Many parents list their children as beneficiaries of their IRA accounts, but this can pose a problem if the children have financial issues or face debt collectors.

But there are a few ways around this: one of the best methods is to establish a trust, such as a conduit trust, and list the trust as beneficiary of the IRA instead of the child. Per Lauren Jenkins, “If the trust is drafted correctly, 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, as if the child—not the trust—was named as the beneficiary.”

The IRA’s required minimum distributions are then calculated based on the trust beneficiary’s life expectancy and income is taxed at the beneficiary’s tax rate. As the assets are not legally owned by the beneficiary, but instead owned by the trust, the assets are protected from creditors in many cases. However, one thing to keep in mind is once the income is paid out to the beneficiary, that income is no longer protected.

At a minimum, it’s a good idea to review your beneficiary designations regularly. Your goals and priorities in life may change from time-to-time, and if your listed beneficiaries are having financial difficulties, you may want to take steps to protect them and protect your legacy.

These laws can change over time, and there may be particular nuances to creditor protection in your state. Speak with a qualified attorney licensed in your state before implementing any changes.

To learn more about how your financial advisor can help with estate planning, read Estate Planning Strategies: How Your Financial Advisor Can Help.