Inherited IRAs are Not Protected From Bankruptcy Creditor Claims

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June 13, 2014

Generally, federal and state bankruptcy laws protect traditional individual retirement accounts (IRAs) from creditor claims. Courts have differed, however, on whether those laws also protect an IRA that is inherited (an “inherited IRA”) by a child or other beneficiary of the account owner.

Historically, Wisconsin courts have taken the position that inherited IRAs are not protected from creditor claims. A bankruptcy case involving Heidi Heffron-Clark, a Wisconsin resident who had an inherited IRA, recently found its way to the United States Supreme Court. She claimed her inherited IRA as an exempt asset in her bankruptcy proceeding. The bankruptcy trustee and creditors objected to the claimed exemption. Yesterday, the United States Supreme Court issued its decision in the case, holding that inherited IRAs are not protected from creditor claims.

What does this case mean for you? If you want to leave retirement assets to your beneficiaries and you want those assets to be protected from the claims of your beneficiaries’ creditors, then you should do two things. First, you should provide in your estate planning documents that upon your death (or upon your surviving spouse’s death), a specially designed trust will be created for each of your beneficiaries. Each trust will be designed to protect assets from the claims of a beneficiary’s creditors, including claims of a divorcing spouse. In addition, each trust will be designed to qualify as a “designated beneficiary” of an inherited IRA the same as if you had named the trust beneficiary as the direct beneficiary of the IRA. This allows the deferred income in the inherited IRA to be “stretched-out” over the beneficiary’s life expectancy.

Second, and just as important, you should sign new beneficiary designation forms for your IRAs, 401(k) plans and other retirement plans. In order to achieve the desired result, you need to provide that upon your death (or upon your surviving spouse’s death), an inherited IRA will be created for each beneficiary of yours and that the IRA will be payable to the separate trust created for that beneficiary.

If you are interested in protecting your retirement benefits from creditor claims by creating protected trusts for your beneficiaries, please contact any of the attorneys in our Trusts & Estates Practice Group.

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