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Inherited IRAs Not Protected in Bankruptcy, Supreme Ct. Rules

By Brett Snider, Esq. on June 13, 2014 | Last updated on March 21, 2019

One of the most popular ways of passing on retirement savings, inherited IRAs, have little protection from bankruptcy after a U.S. Supreme Court ruling issued Thursday.

While other retirement devices are typically protected from creditors during a bankruptcy, the High Court determined that inherited IRAs were not for "essential needs" in the same way as other retirement structures, Reuters reports.

What does this mean for the future or present use of inherited IRAs?

What Is an Inherited IRA?

IRAs are individual retirement accounts which have the benefit of tax deduction either during contribution or dispersal. A Roth IRA has the advantage of being tax-free on dispersal, while a traditional IRA may be fully or partially tax-free when making contributions. The downside is that these funds typically cannot be accessed without a penalty until after retirement, with some exceptions.

However, especially with Roth IRAs, it is incredibly advantageous to allow your relatives to inherit your IRA, as the plan avoids probate and goes straight to the beneficiary. This is accomplished much like assigning a beneficiary for a life insurance policy, and money is available immediately after the IRA's creator dies.

For those who have inherited a Roth IRA in the past, all funds within can be withdrawn immediately, tax-free, for any expenses. But what happens if you go bankrupt?

Supreme Court Says Inherited IRA Is More Like Savings

Whether you've declared personal bankruptcy or your small business is in bankruptcy, most qualified retirement plans will be excluded from the assets available to creditors. Federal courts have even specifically ruled on the exemption for IRAs, saying that employee IRAs are safe in a Chapter 7 bankruptcy. That's because tax-exempt retirement funds are exempt from bankruptcy proceedings under federal law.

But not so fast, Justice Sonia Sotomayor explained. Writing for the majority in Clark v. Rameker, Justice Sotomayor noted that the current law would allow the beneficiaries of inherited IRAs to "escape debt" and dig into the IRA money for "a vacation home or a sports car." This is more evidence that inherited IRAs are not really "retirement funds," the Court argued, as they may be used and withdrawn at any time, even while the beneficiary is employed.

Since the High Court felt inherited IRAs were outside the scope of the "retirement funds" exemption, they are open to bankruptcy creditors in order to satisfy debts.

The Supreme Court's decision may make IRAs slightly less popular as inheritance tools. To learn more about how this ruling may impact your estate plans or your bankruptcy case, consult an experienced estate planning or bankruptcy lawyer near you.

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