You Inherited An IRA. Can Creditors Grab It?

Ashlea Ebeling, 03.17.10, 04:41 PM EDT

More Americans will be handing down IRAs to their kids. A new decision suggests it might be a creditor proof inheritance. But nothing is certain yet.

In what estate planners and bankruptcy lawyers are saying could be a significant case, a federal bankruptcy judge in Minnesota has allowed a bankrupt woman to keep a $63,000 individual retirement account inherited from her father.
IRAs inherited from someone other than your spouse have traditionally not been protected in bankruptcy under either federal or state laws, and thus have been available for creditors to grab. "It’s a huge deal if these IRAs are now protected," said Marc Soss, a tax lawyer in Sarasota, Fla.
The issue is significant not only because more families are facing creditor problems, but also because more of a typical family's wealth is now in retirement accounts. As of the third quarter of 2009, 9% of all household financial assets were in IRAs, up from 4% of assets two decades ago, according to the Investment Company Institute.
Moreover, more of this IRA wealth is likely to be left to children in the future because of a provision that took effect in 2010 allowing all taxpayers to convert traditional pre-tax IRAs into Roth IRAs. In a conversion, you take money out of a traditional IRA, pay ordinary taxes on it and then move it into a Roth, where all future growth and withdrawals are tax free. While retirees are required to begin taking annual distributions from pre-tax IRAs when they turn 70.5, no such requirement applies to Roth IRAs. That means affluent retirees can leave their large Roth IRAs growing untouched, for their children, who can stretch out withdrawals over their own project life spans. (For "10 Reasons To Convert To A Roth IRA," click here.)
In the Minnesota case, In re Nessa, the federal bankruptcy judge relied on new language in the 2005 federal bankruptcy law that protects $1 million in IRA assets from creditors. (The law also protects all assets rolled from an employer pension plan, such as a 401(k) or defined benefit plan, into an IRA, regardless of the amount.) The judge concluded that an inherited IRA is still a retirement account protected under that law, even though it has switched hands from the original owner to the beneficiary. Jean Hannig, the bankruptcy lawyer in Fargo, N.D., who represented debtor Nancy Nessa, hailed the decision as a resounding victory for debtors.
While the Minnesota decision was the first reported case to look at the application of the 2005 law to inherited IRAs, the judge there may not have the last word. The bankruptcy trustee has appealed the ruling to the U.S. Court of Appeals for the 8th Circuit. And earlier this month, a Texas judge in another bankruptcy case, In re Chilton, came to the opposite conclusion of the Minnesota judge.

Spendthrift Trusts in Bankruptcy: It’s a Question of State Law

by Craig Andresen, Minnesota Bankruptcy Attorney · Posted in *Bankruptcy Basics

If you are the beneficiary of a trust, and are considering filing for bankruptcy, you might be wondering if you will lose your interest in the trust to your creditors. The answer to this question depends, first, on whether the trust is a “spendthrift trust” under the law of the state which governs the trust, and second, if the trust contains no valid spendthrift clause, on whether there is an exemption which can be used to protect your interest in the trust.
The law states that a trust becomes property of the bankruptcy estate, unless the trust contains a spendthrift clause enforceable under state law. If so, section 541(c)(2) of the bankruptcy law excludes the trust from the bankruptcy estate, and therefore it is protected. This means your bankruptcy lawyer will need to carefully examine the terms of the trust to see whether it contains a spendthrift clause.
Next, your lawyer will need to determine which state’s law governs the trust, and whether the trust’s spendthrift clause was properly drafted so as to be enforceable. This may a matter of interpreting complex trust law unique to the state involved. Your bankruptcy lawyer may need to seek an opinion from an experienced trust lawyer in order to answer this question.
If the trust contains a valid spendthrift clause, your worries are over, because your interest in the trust is excluded from the bankruptcy estate and you cannot lose it. However, if there is no spendthrift clause, or if the spendthrift clause is defective in some way so as to render it uneforceable under the law of the state involved, your interest in the trust will be lost unless you can claim it exempt.
The federal bankruptcy exemptions contain a “wild card” exemption in the amount of $11,200 which can be used to protect liquid cash assets such as a trust. If the value of your interest in the trust is less than this amount, the trust will be protected. Note that it is only your interest in the trust which needs to be exempted, rather than the entire amount in the trust, which may be subject to the interest of other persons who are beneficiaries of the trust.
If you elect to use the state law exemptions in your bankruptcy, it is possible, although unlikely, that an exemption law might be available to protect your interest in the trust. Some states have exemptions which protect various forms of income, and some states have “wildcard” exemptions which protect liquid cash assets such as trusts. However, such exemptions are usually quite limited, and due to the amounts involved in most trusts, it is not likely that a state exemption law of this nature would be sufficient to protect a trust.
The most favorable scenario is one in which your interest in a trust is subject to valid spendthrift clause, and therefore the trust does not even need to be claimed exempt, because it is excluded from the bankruptcy estate