Imagine this: Like a lot of Americans, Hank has been using the 401(k) offered by his employer as his primary retirement savings vehicle. After 30-plus years of contributions (from him and his employer), it’s grown to more than half a million dollars. Hanks and his wife, Lola, are counting on this money- plus Social Security- to provide a good portion of income in their retirement down the road.
Unfortunately, Hank developed a rare, life-threatening medical condition, and after six months in the hospital, he passes away. Lola inherits the 401(k) and $250,000 in medical bills. She is 55 years old, with a mortgage and two children in high school. Her job barely covers the family’s monthly expenses.
Lola is no dummy. Instead of rolling Hank's 401(k) account into an IRA in her own name, she transfers it to an “inherited” IRA, meaning he is listed as the “owner” of the account and she is named the “beneficiary.”(1) This enables her to access the money in the IRA without having to pay a 10% penalty in case she has to make a withdrawal before she is 59½. (Death of the IRA owner –in this case, Hank- is an exception to the penalty on premature withdrawals.) Once she reaches age 59½ and the penalty no longer applies, she will re-title the account, making herself the owner.
The medical bills pour in. Lola pays what she can, but the doctors and hospital have grown impatient. They turn the bills over to a very persistent collection agency. Lola files for bankruptcy protection, knowing that at least her husband's IRA will be off-limits because it’s a retirement account.
Thanks to a recent decision by the U.S. Supreme Court, IRAs no longer have the same level of bankruptcy protection as some other retirement assets. In the case of Clark v. Rameker, the land's highest court said that “the term ‘retirement account’ is narrowly-defined,” explains attorney Edwin Morrow, wealth specialist with Key Private Bank. Translation: “retirement account” does not apply to assets you receive from someone else.
This ruling is sending seismic shock waves through the estate planning community.
If You Can’t Roll It, You’re Toast
Here’s a critical point to understand: A spouse is the only individual who can inherit retirement assets, move them into a new account and name himself or herself as the new owner.
With that as background, let’s suppose grandma names her three adult grandchildren--Mary, Sally and George--as equal recipients of her $750,000 IRA.
At her death, it is split into three separate IRAs. However, since the grandkids are not grandma’s “spouse,” they cannot replace her as the owner. Instead, grandma’s name will remain on each IRA, with a different grandchild named as beneficiary. The three “beneficiary” (a.k.a. “inherited”) IRAs will be titled similar to: “Grandma’s IRA for the benefit of Mary,” Grandma’s IRA for the benefit of Sally” and “Grandma’s IRA for the benefit of George.”
In George’s case, this inheritance is a lifesaver. Divorced and in his late 40s, he has never managed to save much for retirement. Now, thanks to grandma, it looks like he will be able to afford a more secure retirement than he had hoped. Unfortunately, as luck would have it, George gets laid off. Unpaid bills pile up. When creditors start threatening, he files for bankruptcy protection. That’s when he learns that the first thing the attorneys for his creditors are going to go after is the easy money: grandma’s IRA.
Is there anything that Lola or George could have done to safeguard their inherited IRA from creditors?
If A Spouse Inherits:
A spouse who inherits a retirement account has more options than a non-spouse beneficiary. Here are Lola’s choices:
1. Leave the assets in her husband’s 401(k) plan, i.e. in his name. This move is rarely permitted. Most plans require a beneficiary of any type to empty the account within a year after the employee dies.
2. Roll her husband’s 401(k) balance into the retirement account she has with her own employer. This move transforms “his” retirement money into “her” retirement money. In addition, a company-sponsored retirement plan such as a 401(k) is off-limits to creditors in the event of bankruptcy. Her plan may or may not accept rollovers from other company retirement plans.
3. Roll her husband’s 401(k) balance into an IRA in her name. Once this becomes “Lola’s” IRA, she would be subject to a 10% penalty if she needs to take a withdrawal before she is 59½. Despite this, in the wake of the Clark decision, if the first two moves are not an option, this is probably the smarter choice. According to Morrow, “You get more asset protection” if you roll it into an IRA in your own name.
If the surviving spouse is over age 59½, it’s a no-brainer: Rollover the assets into an IRA that lists him/her as the owner.
If a spouse chooses to rollover the account into his/her own name, Morrow suggests doing it as soon as possible. Otherwise, the spouse could be accused of “fraudulent transfer.” That’s what the law calls it when a person deliberately tries to reduce assets by giving them away, changing the title of property, etc..., so that there is less for creditors to confiscate. As a result, Morrow cautions those that live in a state such as California or Maine, “even a rollover IRA could be subject to creditors in bankruptcy.”
Certified Public Accountant Bob Keebler, who lectures around the country on family wealth transfer and preservation planning, raises the issue of using a “disclaimer.” This legitimate strategy allows a primary beneficiary- say, a spouse- to choose not to accept the bequest of a retirement plan, allowing it to pass to a secondary beneficiary such as a child. Could creditors argue that this was “unlawful conveyance” on the part of the surviving spouse?
To complicate matters more, the rules that apply in bankruptcy court depend upon both federal as well as state law. So, even if a deceased spouse’s retirement account is rolled into an IRA titled in the surviving spouse's name, that doesn't guarantee safety from creditors unless he or she lives in one of seven states (Alaska, Arizona, Florida, Idaho, Missouri, North Carolina, Ohio and Texas) that have laws giving inherited IRAs the same bankruptcy protection as IRAs titled in the name of the original owner.
If a Non-Spouse Inherits:
Since non-spouse beneficiaries are prohibited from moving inherited retirement assets into an account in their own name, they have no choice but to leave the original owner’s name on the title. Again, this type of IRA is called an “inherited” or “beneficiary” IRA.
While a spouse might argue that the money his wife was saving in her 401(k) was meant to benefit both of them in retirement, there is no way a non-spouse beneficiary could make a case for this. In fact, in writing the unanimous decision for the court, Justice Sonia Sotomayor pointed out that beneficiaries of an inherited (or “beneficiary”) IRA did not deserve bankruptcy protection because the assets could be used for anything they wished:
“…nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete…” she wrote.
Although even non-spouse beneficiaries get protection from creditors if they live in a state that protects inherited retirement assets from creditors, they can bet that bankruptcy attorneys will use the Clark decision to argue otherwise.
In fact, in light of the Supreme Court’s unanimous decision, Morrow says individuals who want to leave sizeable retirement accounts to non-spouse beneficiaries, should not name them directly on the beneficiary form. Instead, Morrow recommends using a “see-through” trust. He stresses that it’s critically important the trust be drafted correctly. Your best bet is to use an experienced estate planning lawyer. He adds that “because the rules can be complex, it may be safer to have a separate trust” just for retirement assets.
In fact, those that are extra-cautious, might want to consider a see-through trust for the retirement assets left to a spouse.
It’s Just the Beginning
This Supreme Court decision has reversed a longstanding trend of making retirement assets harder for creditors to get their hands on.
“It is completely unfair not to protect a spousal inherited IRA,” asserts Morrow. He points out that normally “money contributed to an IRA or 401(k) is considered ‘marital property.’” In fact, if the couple got divorced, it would be split 50-50- a clear indication that the spouse who did not contribute to the account none-the-less owns half of it.
In Morrow’s opinion, “Congress should create a special exemption” to protect spouses who inherit retirement assets.
Unfortunately, at this point we are left with more questions than answers. Keebler predicts “there’s no quick resolution” on the horizon. “The Supreme Court will have to decide these issues.” Morrow expects to see “court cases all over the country” as bankruptcy attorneys go after inherited retirement assets. And endless appeals.
1. Also known as a “Beneficiary IRA.” The title is along the line of “Fred Smith’s IRA for the benefit of his wife Helen Smith.”