Can Creditors Reach Your IRA?

At some point in your life, you may be faced with a large judgement against you or even be forced to declare bankruptcy.  In that event, there are certain assets that are protected under the law.  One of the major categories of protected assets is retirement plans.  This is true in all states.  (There are exemptions under the federal bankruptcy laws, but each state also has its own exemptions.  If you file for bankruptcy in Illinois, you are required to use the Illinois exemptions.  Some states have much more generous exemptions than Illinois.)

Under Illinois law, all assets in a retirement account governed by ERISA (employer sponsored retirement accounts) such as 401(k)s, 403(b)s, SEPs and Simple IRAs are fully exempt.  Traditional IRAs and Roth IRAs are also exempt, although under the federal exemptions protected amounts in these IRAs are limited to $1,245,475 (as adjusted every three years for inflation).

Although the principal in your retirement account is exempt, once you remove assets from the account, they are no longer exempt.

These rules for your own retirement accounts that are funded with your earnings are clear.  What has not been clear is whether or not a retirement plan continues to be protected after the death of the participant.  For example, your mother had a 401(k) and at her death left the plan to you.  Her employer will generally require you to take a distribution of the plan assets.  If you want to continue to defer income tax on the plan, you will roll the proceeds over into an IRA in your name.  This is called an "inherited IRA."  You will be required to take distributions from the plan every year regardless of your age, i.e., you do not have to wait until you turn 59½, nor can you wait until you turn 70 ½.  How quickly you are required to take the distributions will depend on your mother's age when she died.  Distributions will be different if she died before her "required beginning date" (age 70½) or after her RBD.

Illinois law provides that "a debtor's interest in or right, whether vested or not, to the assets held in or to receive pensions, annuities, benefits, distributions, refunds of contributions, or other payments under a retirement plan is exempt from judgment."  (Other states' laws have similar language.)  On its face, this would appear to include all retirement plans, whether they are inherited or not.  The Seventh Circuit Court of Appeals, however, has held otherwise under federal law in In re Heidi Heffron-Clark which was decided on April 23, 2013.  (Although bankruptcy in Illinois uses Illinois exemptions, all bankruptcies are filed in the Bankruptcy Court, which is a federal court.  Appeals are taken to the District Court, then the Court of Appeals, and then the U.S. Supreme Court. The Clark bankruptcy was filed in Wisconsin and decided under the federal exemption rules.)

In the Clark case, Ruth Heffron owned an IRA worth approximately $300,000.  Ruth's daughter Heidi Heffron-Clark was the designated beneficiary.  Ruth's account passed to Heidi at Ruth's death.  Heidi and her husband subsequently filed for bankruptcy.  The appellate court ruled that the inherited IRA was not exempt in bankruptcy because the funds did not constitute "retirement funds" as to Heidi.

The appellate court made this determination in part because "instead of being dedicated to Heidi's retirement years, the inherited IRA must begin distributing its assets within a year of the original owner's death. . . An inherited IRA does not have the economic attributes of a retirement vehicle, because the money cannot be held in the account until the current owner's retirement."

The Court of Appeals apparently does not want its ruling to apply to married persons.  It stated, "If a married holder of an IRA dies, the decedent's spouse inherits the account and can keep it separate or roll it over into his or her own IRA.  Either way, the money remains "retirement funds" in the same sense as before the original owner's death: the surviving spouse cannot withdraw any of the money before age 59½ without paying a penalty tax and must start withdrawals no later than the year in which the survivor reaches 70½."  This statement, however, is incorrect.  A surviving wife can withdraw her husband's entire IRA at his death without penalty regardless of her age.  In light of this discrepancy, it is not clear whether or not a surviving spouse's interest will be protected, at least if she does not roll the account over into an IRA of her own.

Although the Seventh Circuit held that inherited IRAs are not protected, the Fifth Circuit (covering Texas, Louisiana and Mississippi) and the Eight Circuit (covering the Dakotas, Minnesota, Iowa, Nebraska, Missouri and Arkansas) have held that they are protected.  In order for this matter to be resolved, a determination will have to be made by the U.S. Supreme Court or by a legislative change by Congress.

Is it possible then, to protect inherited IRA assets?  Yes, it is, by means of a trust.  If Ruth Heffron had named a spendthrift trust as the beneficiary of her IRA rather than her daughter Heidi, the assets it could have been protected in bankruptcy.  However, naming a trust can be disadvantageous for income tax purposes.  Depending upon the terms of the trust, the assets may need to be withdrawn over a five year period instead of the beneficiary's life expectancy, resulting in a loss of deferral and likely a higher tax bracket.  Therefore, an IRA owner must weigh the benefits of tax deferral versus the protection of trust assets from creditors and name her beneficiaries accordingly.