When a person declares bankruptcy, an individual retirement account (IRA) is one of the assets that is beyond the reach of creditors, but what about an IRA that has been inherited?  Resolving a conflict between lower courts, the U.S. Supreme Court in 2014 unanimously ruled that funds held in an inherited IRA are not exempt from creditors in a bankruptcy proceeding because they are not really retirement funds. Clark v. Rameker (U.S., No. 13-299, June 13, 2014).

This ruling has significant estate planning implications for those who intend to leave their IRAs to their children.  If the child inherits the IRA and then declares bankruptcy sometime in the future, as a result of the Supreme Court ruling the child’s creditors could take the IRA funds. Perhaps even more alarming are various threats to an inherited IRA outside the context of an heir’s bankruptcy. These include divorce, improvident spending, and exposure to creditor claims generally, not just in bankruptcy.

Fortunately, there is a way to still protect your IRA funds from your child’s potential creditors.  How? Leave the IRA after you pass away not to the child but to a “spendthrift” trust for the child. The trustee, a corporate entity, makes distributions to or for the benefit of your beneficiaries in accordance with distribution standards you formulate and include in the trust instrument. Stanley Vasiliadis, an attorney with the law firm of Vasiliadis Pappas Associates, cautions that, “whenever a corporate entity is selected as a trustee, it is prudent to include provisions allowing for  removal and replacement of the trustee under appropriate circumstances since the trust is irrevocable and cannot be a traditional revocable living trust; rather, it must be a properly drafted IRA trust set up by an attorney who is familiar with the issues specific to inherited IRAs.

In Pennsylvania, an IRA trust, provided it includes the right language, will be protected from your heirs’ creditors. But the extent of protections available to IRA trusts vary from state to state. Nevertheless, no matter which state you are in, the safest course if you want to protect a child’s IRA from creditors is to leave it to a properly drafted trust.

Contact Vasiliadis Pappas Associates to learn more about your options and other measures to protect your IRA or other qualified retirement plan.