INHERITED IRAS LOSE BANKRUPTCY PROTECTION
In Clark v. Rameker, the U.S. Supreme Court unanimously held that inherited individual retirement accounts (“IRAs”) are not exempted from an IRA beneficiary’s bankruptcy estate, thereby exposing such inherited IRAs to the claims of creditors. Subject to certain limits, the U.S. Bankruptcy Code exempts retirement funds from the bankruptcy estate of an IRA account owner who files for bankruptcy. However, based on the Court’s recent decision, the bankruptcy exemption does not extend to IRAs which are inherited from a deceased account owner. The Court’s decision resolves an issue with respect to which U.S. Courts of Appeal have reached differing conclusions.
Issue Presented in Clark. In Clark, an individual inherited an IRA upon her mother’s demise and subsequently filed for bankruptcy. The bankrupt individual claimed that the IRA she inherited from her mother was exempt from her bankruptcy estate because the funds constituted “retirement funds” within the meaning of the Bankruptcy Code. The bankruptcy trustee objected to the exemption. The Supreme Court sided with the bankruptcy trustee, ruling that funds in an inherited IRA are not retirement funds entitled to exemption.
Clark Analysis. The Supreme Court based its decision on three distinctions between conventional IRAs and inherited IRAs. First, the beneficiary of an inherited IRA cannot make contributions to such account as can the owner of a conventional IRA. Second, an inherited IRA beneficiary must immediately commence receiving the distribution of inherited IRA funds following the owner’s death, whereas conventional IRAs offer owners an opportunity to defer distributions until age 70 & ½ and thereby defer the accompanying tax obligation. Third, the beneficiary of an inherited IRA can withdraw the funds without penalty, whereas the owner of a conventional IRA who has not reached the age of 59 & ½ can avoid incurring penalties on IRA distributions only in certain circumstances. Due to the fundamental differences between an inherited IRA and a conventional IRA, the Court concluded that affording bankruptcy protection for beneficiaries of inherited IRAs would distort the purposes of the statutory exemption.
Exception for Spousal Beneficiaries. The Supreme Court’s opinion appears to distinguish IRA benefits that are payable to a surviving spouse and are rolled-over by the spouse to his or her own IRA, with the Court indicating that the spouse’s rollover IRA would receive bankruptcy protection as a retirement account. The rollover by the spouse subjects the IRA to the same restrictions and requirements as a conventional IRA.
Use of a Spendthrift Trust. IRA owners who intend to pass the IRA to non-spousal beneficiaries upon death should consider the potential claims a bankruptcy trustee can make against such assets. As an alternative, inherited IRA assets payable to a trust for the intended beneficiary can overcome the impact of the Clark decision, as a properly drafted spendthrift trust can be created to hold assets which are outside the reach of the trust beneficiary’s prospective bankruptcy trustee and the creditors of the beneficiary. The use of a spendthrift trust requires attention to the income tax consequences of retirement distributions retained in trust, as the highest income tax rate, currently 39.6%, applies to trust income above a very low threshold ($12,150 for 2014). However, having an IRA paid to a properly-designed trust for a beneficiary rather than to the beneficiary directly is an important asset protection technique which should be considered as part of any estate plan where creditor protection might be needed for a child or other non-spousal beneficiary, and the spendthrift trust can also be used as a receptacle for other assets to be gifted to the beneficiary.
Conclusion. As a result of the Clark decision, greater attention is required to IRA beneficiary designations. This is particularly important when a designated beneficiary has potential creditor claims that might result in a bankruptcy filing and the individual retirement account has enough value to merit the use of a spendthrift trust to receive the IRA distributions.
By Bruce E. Bell
THE IMPORTANCE OF A PERIODIC REVIEW OF AN ESTATE PLAN
An estate plan is not a static set of documents. Even if a person has completed the proper documents to achieve personal and family goals, which incorporate federal and state tax saving provisions and which provide that his or her wealth will be distributed upon death according to the instructions provided in those documents, a regular review of an estate plan is important to avoid unintended consequences of out-of-date documents. Not only do changes in the tax laws and other laws need to be considered, but so do changes in a person’s circumstances.
While changes in a person’s life and the lives of loved ones are important on a personal level, they often have significant implications that require adjustments to an estate plan. A review of an estate plan, including a will, trust, power of attorney for property, power of attorney for healthcare, insurance and retirement account beneficiary designations and related estate planning documents is recommended whenever someone experiences a major life event. Events that may require an estate plan review include the following:
Change in Marital Status: Divorce, separation or death of a spouse, or a change in the marital status of a person’s children, grandchildren, or parents.
Additions to the Family: Birth, adoption or having step-children (as a result of a marriage) or other changes in the family group.
Onset of Health Issues: Illness, incapacity or death of any family member, or the mental or physical health status of any guardians, beneficiaries, executors, or trustees named in the estate plan documents, including agents pursuant to a power of attorney for healthcare or power of attorney for property. If named agents, executors, or trustees are no longer capable of serving, then other persons must be designated for those positions.
Changing Estate Value: A substantial change in a person’s net worth due to an increase or decrease in investment portfolio value or inheritance, or a change in income level or other causes.
Business Ownership Changes: The sale or purchase of a closely-held business interest and any accompanying buy/sell agreements, employee benefit plans, 401(k) plans, pension plans, or other deferred compensation plans.
New or Changing Insurance Coverage: Purchase or lapse of life, health, long-term disability, liability or other insurance coverage.
Purchase of Out-of-State Property: Unless held in trust or in joint tenancy, any property located in another state will be subject to the laws (and probate) of that state.
Change in Residency: An estate plan is subject to the laws of the state in which a person is domiciled, not where the estate plan was created. State laws differ with regard to tax treatment, spousal rights, and execution requirements, such as witnesses, notarizations, and what provisions should be included in the estate plan documents to meet the applicable state law requirements.
Illinois Healthcare Power of Attorney. As an example of law changes, the Illinois Statutory Healthcare Power of Attorney has been amended by legislation that is effective January 1, 2015. While the new power of attorney for healthcare law does not invalidate any healthcare powers executed prior to the January 1, 2015 effective date of the law, the new statutory form provides an opportunity to provide better guidance to the healthcare agent as to possible decisions to be made and allows decisions to be made by an agent at any time, without requiring that a person be unable to make his or her own decisions.
Conclusion. Barring any of the above-listed personal or family developments, a general guideline is that a thorough review of an estate plan should take place at least once every five years. However, an annual or biennial review is recommended to evaluate the effects any changes in tax laws or other laws may have on an estate plan. For example, as a result of changes made to the federal estate tax law, effective January 1, 2013, a review of most estate plans is now in order.
By Gerald M. Newman
Practice Spotlight: Estate Planning, Probate, and Asset Protection
In addition to providing customary estate planning services, such as preparing wills, living trusts, powers of attorney, and insurance trusts, Schoenberg, Finkel, Newman & Rosenberg, LLC counsels clients in more sophisticated tax, asset protection, and planning strategies, such as:
grantor retained annuity trusts,
asset protection trusts, and
gift tax returns
The Firm’s probate and trust law practice includes decedents’ estates, guardianships, estate and trust administration, and post-mortem tax planning. It also includes the preparation of federal and state estate tax returns and fiduciary income tax returns.
Schoenberg Finkel Newman & Rosenberg, LLC (312) 648-2300
This newsletter is not intended to be legal or tax advice and is not a substitute for obtaining legal or tax advice. This Newsletter is deemed to be advertising material by the Illinois Supreme Court.