New IRS Ruling on Inherited IRAs and Bankruptcy Protection

The Supreme Court recently ruled that inherited IRAs are not protected from bankruptcy creditors and upheld a U.S. Court of Appeals for the Seventh Circuit Court decision. In this case, Heidi Heffron-Clark inherited an IRA in 2001 originally worth about $450,000. Ten years later when Clark and her husband declared bankruptcy because of a failed business, they said that the remaining $300,000 in the inherited IRA was protected from creditors since the IRA was defined as "retirement funds", and therefore, because IRA funds qualify for a bankruptcy exemption, the inherited IRA funds were protected from creditors in the bankruptcy.

The Supreme Court ruled that there is no bankruptcy protection for inherited IRAs since inherited IRAs don't meet the same definition as regular IRAs. The Court stated although some heirs may use their inherited IRAs for their retirement needs (thus meeting the definition of "retirement funds"), that does not mean that they will, and therefore the inherited funds do not meet the definition of a true retirement account. Other reasons given for the Court's decision in making the distinction:

•1. Inherited IRAs were not originally funded by the heirs.

•2. IRA beneficiaries cannot make additional contributions to the account; only withdrawals can be made.

•3. IRA beneficiaries have access to the funds immediately, and must take annual minimum distributions regardless of their age.

•4. Early withdrawal penalties don't apply to inherited IRAs.

If you have money left in your IRA that you are leaving to your heirs, you may want to consider setting up an irrevocable trust and naming your heirs as trust beneficiaries.

This recent Supreme Court ruling will most likely continue to be an issue for Congressional debate. Many baby boomers do not have enough set aside in their own retirement accounts and rely on future inheritances; if they lose access to these inherited "retirement" funds because of bankruptcy, they could suffer dire consequences beyond the bankruptcy itself.