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Navigating Around An Inherited IRA Pitfall

Even the most avid followers of the Supreme Court’s docket may have passed over the recent decision in Clark v. Rameker with a shrug.

A ruling on IRAs lacks the headline appeal of more politically charged cases like those concerning same-sex marriage or the Affordable Care Act. However, there was a reason that Larry Elkin suggested retirement savers keep an eye out for this case last winter. The decision may have a direct impact on your life - specifically, your estate plan - in a way that other, more media-ready cases will not.

The point of contention in Clark v. Rameker is how the Internal Revenue Service should treat funds in an IRA that the owner has inherited upon the original owner’s death. In a unanimous decision, the Supreme Court drew a sharp distinction between inherited IRAs and other retirement accounts, ending a series of back-and-forth decisions on the matter from the lower courts.

Heidi Heffron-Clark inherited an IRA from her mother, Ruth Heffron, in 2001 upon Heffron’s death. Nine years later, Heffron-Clark and her husband filed for bankruptcy, but claimed that the inherited IRA was sheltered from creditors’ claims, just as an IRA she established herself would have been. Justice Sonia Sotomayor, who wrote the Supreme Court’s opinion, said the Bankruptcy Code makes it clear that inherited IRAs no longer qualify as retirement funds for three reasons: The holder of an inherited IRA may not make additional contributions to the account; the holder must withdraw money from the inherited IRA, regardless of the holder’s age; and the holder may withdraw the entire balance at any time, for any reason, without penalty. Because of these characteristics, the Court said, it is clear that such accounts should not be treated as retirement funds.

On its face, I believe this decision makes sense. The intent of the bankruptcy provision protecting retirement funds is to ensure individuals who file bankruptcy have some assets to meet their needs during retirement. In the case of a traditional or Roth IRA, restrictions on distributions ensure that the funds will most likely be used during retirement. With some exceptions, owners of such accounts cannot make withdrawals before age 59 1/2 without facing a 10 percent penalty. There is no provision, however, that would inhibit a person from distributing the assets held in an inherited IRA as they please.

Ruth Heffron did not incur debts to her daughter’s creditors, and she presumably intended to use her IRA money primarily for her own retirement needs. Her early death prevented her from doing so, and according to the Supreme Court, eliminated retirement as a principal purpose of the inherited IRA. Had Heffron bequeathed an ordinary brokerage account to her daughter rather than an IRA, Heffron-Clark’s creditors would have been able to make claims against the inheritance. The high court saw no reason to treat the inherited IRA funds differently.

So what does the decision mean for current IRA account holders?

First, it is important to note that if you name your spouse as your IRA’s beneficiary, the rules are a bit different than they are for others. Your spouse can treat an inherited IRA as his or her own, by rolling it over to an IRA in his or her own name. The inherited IRA’s assets would then be subject to the same rules as ordinary IRAs, including protection from creditors. However, spousal beneficiaries under 59 1/2 years old should not automatically proceed with such rollovers. If the surviving spouse needs to use the inherited IRA funds, the 10 percent penalty will apply to withdrawals from the rollover IRA. Withdrawals from the deceased spouse’s IRA are not subject to the early withdrawal penalty. It is therefore a good idea to leave enough assets in the inherited IRA to cover the survivor’s anticipated current needs and roll over the remainder.

If you plan to name anyone other than your spouse as your IRA’s primary (or secondary) beneficiary, the decision in Clark v. Rameker means you may want to consider a more sophisticated estate planning arrangement. A sensible alternative is to name a trust established for your heir (or heirs) as the IRA’s beneficiary. The trust would then serve to shelter the IRA assets from the beneficiary’s creditors in the case of bankruptcy.

Individuals who take this approach should carefully comply with the IRS’ rules to construct what is known as a “see-through” trust. Otherwise, you may trigger a requirement to pay out the IRA within five years of the original owner’s death, thus mainly defeating the trust’s purpose. Professional help is almost always advisable when setting up a trust, but in this case, you should be especially careful that the trust is set up properly.

Trusts also have disadvantages. They can be expensive to establish and maintain, and may be unnecessary if your beneficiary never faces bankruptcy, divorce or other legal claims. Setting up a trust as your IRA beneficiary also means your spouse can no longer roll over the IRA if desired. Important to note, too, is that separate account treatment is never available for benefits paid to or through a trust, which means distributions will be based on the life expectancy of the oldest beneficiary if the trust has multiple beneficiaries. The rules for determining the oldest beneficiary are not always intuitive.

Do you need a trust if you plan to name someone other than your spouse as the beneficiary of your IRA? Like most estate planning choices, it depends. You should weigh the extra protection of a trust against the work and expense of setting up and administering it. You may also want to frankly consider the likelihood that your beneficiary will need such protection – being mindful that a person’s financial situation can change unexpectedly.

Clark v. Rameker may not hold the cachet of other Supreme Court decisions. But for retirement savers making choices about IRA inheritance, its impact will be felt far and wide.

Client Service Manager ReKeithen Miller, who is based in our Atlanta office, is the author of Chapter 6, “Should I Buy Or Lease A Vehicle?” in our firm’s most recent book, The High Achiever’s Guide To Wealth. He also contributed to the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.

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