Inherited IRAs – Bankruptcy Protection?
By Andy Ives, CFP®, AIF®
IRA Analyst
Just over 10 years ago, in June 2014, the U.S. Supreme Court ruled unanimously, 9-0, that inherited IRAs are NOTprotected in bankruptcy under federal law. The primary issue before the Court was whether an inherited IRA is a “retirement account.” Considering the fact that “inherited IRA” is short for “inherited individual retirement arrangement,” this would seem like an odd question to debate. The word “retirement” is right there in the name. Nevertheless, the Supreme Court felt that three primary characteristics of inherited IRAs were not features of a “retirement” account. Those three characteristics were:
Beneficiaries cannot add money to inherited IRAs like IRA owners can to their own accounts. This is true. If a person inherits an IRA from any other person, that beneficiary cannot make any contributions to the inherited IRA. The beneficiary cannot roll over any of their own IRA dollars into that inherited IRA, and they cannot do any Roth conversions with the inherited IRA. Of course, a spouse beneficiary has the option of doing a spousal rollover of the inherited account into her own IRA. The surviving spouse can then make contributions to the account, but this account is no longer considered “inherited.” After a spousal rollover, the account is deemed to have been owned by the surviving spouse since Day 1 and is hers to do with as she pleases.
Beneficiaries of inherited IRAs must generally begin to take required minimum distributions (RMDs) in the year after they inherit the account, regardless of how far away they are from retirement. Remember, this Supreme Court ruling came down in 2014, well before the SECURE Act. Back in the day, under the old rules, any living, breathing beneficiary could set up an inherited IRA and start taking annual RMDs in the year after the year of death. (Now we have the 10-year rule for certain beneficiaries, and annual RMDs do not always apply within the 10-year period.) These annual “stretch” RMDs are based on the beneficiary’s single life expectancy. Annual RMDs do not apply to the original IRA owner until he reaches RMD age (currently age 73). Since annual RMDs applied to beneficiaries at any age (again, under the old rules), then inherited IRAs are NOT retirement accounts.
Beneficiaries can take a total distribution of their inherited IRA at any time and use the funds for any purpose without a penalty. IRA owners under age 59½ cannot take lifetime, penalty-free distributions from their own IRA unless an exception to the 10% early withdrawal penalty applies. The 10% penalty does not apply to distributions from an inherited IRA. A beneficiary at any age can completely drain the inherited account without penalty (although taxes may apply). Therefore, inherited IRAs are NOT retirement accounts in the eyes of the Supreme Court.
A handful of states disagree. For example, Idaho does offer bankruptcy protection to inherited IRAs. But for most inherited IRA owners, it is important to recognize that the favorable bankruptcy protection afforded to such funds under the Federal Bankruptcy Code does NOT extend to them. Based on the Supreme Court’s reasoning on the three items above, this seems like a sensible conclusion.