OK, here’s the scenario. 

Your son, Rodney, has never been able to manage money.  Although nearly 40, he’s still coming to dear ol’ dad to “borrow” cash because pick one: a) he doesn’t have enough to cover his monthly mortgage payment; b) he’s two months behind in paying his auto insurance; c) he needs help to cover his daughter’s recent tonsillectomy; d) he blew his last paycheck at the track but is afraid to tell his wife; e) etc., etc.

The reasons range from the mundane to the highly creative, but the end result is the same: you’ve become a human ATM for your child. 

Still, you love him just the same, so you keep bailing him out.  And you worry about what’s going to become of him when you’re no longer around. 

Then one day you hear about the federal bankruptcy law passed in 2005.  It shields up to a million dollars in IRA assets from creditors.  A light bulb goes off in your head: you’ll leave your IRA to Rodney!  Even if hungry creditors are banging on his door, they won’t be able to get their hands on the IRA money.

Nice try.

First of all, to get creditor protection under the new law, you have to actually file for bankruptcy.  “Not a problem,” you think to yourself.  “Without me around, there’s a very good chance Rodney will have to file for bankruptcy.”

Sorry.  Veteran estate planning attorney Seymour Goldberg of Garden City, NY, says state courts have repeatedly ruled that federal creditor protection of IRA assets only applies to the owner of the IRA – not the beneficiary!

“Everyone’s very upset,” says Goldberg, putting it mildly.  “An inherited IRA does not have creditor protection.”  In fact, legal and financial planning professionals are just starting to realize that some of the supposedly “tried and true” strategies they’ve used to help clients pass assets to heirs are useless.  Goldberg, who discovered this loophole in the law, has been trying to get the word out. 

According to Goldberg, “All states say that IRAs are creditor-proof.”  The question is what happens when you die?  Does the protection given to your IRA transfer to your beneficiary?

Those who argue that the answer is “Yes” have gone to court in six different states- Alabama, California, Illinois, Oklahoma, Texas, and Wisconsin.  They lost every time. 

Why is this a state issue and not a federal one?  Because state law spells out creditor rights, i.e. the rights of an individual or entity to collect the money it’s owed.

Apparently, the reasoning of the courts that have heard these cases is that when an IRA or other retirement account passes to a beneficiary at the death of the owner, it ceases to be a “retirement” asset which is protected by federal law and turns into an “inheritance.”

The only exception is when the beneficiary is the spouse.  In this case, the courts have held that the account remains a retirement asset.

The bottom line: If you plan to leave your IRA or other retirement account to someone other than your spouse, keep in mind that it will probably not be out of the reach of creditors.  This isn’t a concern, of course, if your beneficiary is responsible about handling money and doesn’t have any creditor problems.

However, if your beneficiary is like Rodney, Goldberg says the only way to keep creditors from grabbing your IRA is to leave it to “an irrevocable, discretionary spendthrift trust.” 

He predicts this is an issue that must ultimately be decided by the U.S. Supreme Court.

Hope this helps,

Gail