Commentary: Supreme Court strips retirement account protections

Imagine this: You’ve worked hard to save money in your individual retirement account (IRA) or 401(k).

You do the right thing by selecting beneficiaries and rest easy knowing the money will be safe for heirs after you are gone.

Years later, your child inherits your retirement account and is soon laid off from work. A new job is proving difficult to find, and bills are spiraling out of control. The only way out is to file for bankruptcy, which the child does, believing the retirement account will at least be there as a nest egg during hard times ahead.

After all, 401(k)s and IRAs are generally considered off limits if an account holder files for bankruptcy. This helps to ensure that the individual has enough money for retirement, despite any current financial troubles. Surely an inherited retirement account would be afforded this same protection, right?

Wrong.

For decades, courts across the country have struggled to determine if inherited retirement accounts should be afforded the same bankruptcy protection as traditional IRAs.

The Supreme Court recently put an end to all the confusion in the case of Clark vs. Ramaker by ruling that inherited IRAs are not actually retirement funds within the meaning of federal bankruptcy law. The court cited three major differences between traditional IRAs and those that are inherited:

• The beneficiary of an inherited IRA cannot make additional contributions to the account, while an IRA owner can.

• The beneficiary of an inherited IRA must take minimum distributions from the account, regardless of how far away the beneficiary is from actually retiring, while an IRA owner can defer distributions until age 70½.

• The beneficiary of an inherited IRA can withdraw all of the funds at any time, and for any purpose, without a penalty, while an IRA owner must generally wait until age 59 ½ to take penalty-free distributions.

Simply put: Although an inherited IRA was at one time a retirement account, the beneficiary does not have to use it for that purpose. There is nothing stopping the beneficiary from withdrawing the funds at any time to finance luxury vacations, new cars, a home or any other purchase.

Since the inherited IRA can be used as discretionary income, the high court held that it is not a retirement account per se, and the funds can be used to satisfy creditors’ claims if a beneficiary files for bankruptcy.

In order to protect a retirement account for heirs or a surviving spouse, many estate-planning lawyers are recommending that clients set up a Standalone Retirement Trust. This legal tool makes the money inaccessible to any future creditors of the trust’s beneficiary because the trust was not established or funded by the beneficiary.

Remember, if the account is not in the beneficiary’s name, it can’t be seized. And when done properly, the trust’s distributions can be made in a manner similar to how they would have been distributed from the IRA — without the risk of loss to the beneficiary’s creditors.

Attorney DARLYNN MORGAN practices law in Newport Beach.