The effect of the Supreme Court’s ruling on inherited IRAs
(Editor’s note: This is a guest blog on a recent Supreme Court decision that will likely change future investing practices.)
You may want to keep a very close eye on your retirement portfolio right now if it includes any inherited IRAs.
On June 12, the U.S. Supreme Court ruled that inherited individual retirement accounts do not qualify as “retirement funds” for purposes of a federal bankruptcy exemption.
The federal bankruptcy exemptions are a list created by Congress determining what an individual in bankruptcy may keep during and after declaring bankruptcy. All states have their own set of exemptions bankruptcy filers may use, but this ruling solely addresses the exemptions for a federal bankruptcy. This ruling resolves a conflict among the federal circuit courts over this issue and applies to inherited traditional and Roth IRAs.
The court’s opinion centered on several legal characteristics of inherited IRAs that demonstrate that these types of accounts are not within the ordinary meaning of “retirement funds”:
• The beneficiary of an inherited IRA may not invest additional money in the account, while an account owner is able to invest additional money into their own IRA.
• The beneficiary of the inherited IRA is required to withdrawal funds from the account all at once, over five years or through minimum distributions — regardless of how far he or she may be from retirement.
• The entire balance of an inherited IRA can be withdrawn at any time, for any reason and without incurring the 10 percent penalty for early withdrawals that applies to a traditional IRA.
The ruling does not change the protections currently afforded to IRA owners. If the debtor had been the original IRA owner, the IRA would likely still be shielded under a bankruptcy exemption.
The ruling has provided some important planning considerations. First, a surviving spouse may consider “rolling over” the decedent spouse’s IRA rather than inheriting it. The survivor might do this because a rollover into the surviving spouse’s name would preserve the creditor shield for federal bankruptcy and would not be considered an inherited IRA.
However, as owner, the surviving spouse would be subject to the same withdrawal rules (10 percent penalty for early withdrawal, minimum distributions at age 70-and-a-half) as the decedent owner. Setting aside federal income taxation considerations, an IRA owner concerned about this issue may consider naming a trust as the beneficiary to receive the IRA, creating a shield for the IRA assets.
This is particularly helpful in situations where an IRA owner has concerns about the beneficiary’s financial situation or financial management abilities, now or in the future. The IRA owner could also withdraw IRA assets and place those assets in trust.
It is important to note that this ruling only applies to federal bankruptcy. In Pennsylvania, IRA assets are protected from a debtor-owner’s creditors by statute in many situations. Pennsylvania also protects several asset types from the reach of creditors, including annuities and life insurance death benefits if certain qualifications are met.
Pennsylvania courts have not addressed this issue of whether the inherited IRA of a debtor-beneficiary will be protected from creditors, whether in bankruptcy or otherwise. Other states, such as Florida, have made it clear by statute that an inherited IRA is protected from the beneficiary’s creditors.
It’s important to consult with your tax adviser regarding your IRA planning decisions in the wake of the court decision.
Drew Horwitz is a vice president at Wilmington Trust’s Harrisburg office. He can be reached at firstname.lastname@example.org.