For those of us who have built a nest egg in our IRAs intending to secure a strong retirement and to leave funds for our children, a basic but little known surprise awaits the next generation:
Your IRA is in most instances fully protected from your creditors during your lifetime. But when the IRA continues as an inherited IRA for your kids after your death it is NOT protected from your children’s creditors.
Under Illinois law, plaintiffs can successfully garnish an inherited IRA because state exemptions protecting retirement assets from creditors generally do not extend to non-spousal beneficiaries. The 2014 U.S. Supreme Court ruling in Clark v. Rameker followed the same approach under federal law, establishing that inherited IRAs are not considered “retirement funds” for bankruptcy purposes.
That’s right. If your children now have or may likely have creditor issues after you have passed, your valuable IRA will be reachable by your children’s creditors.
Why is this important? Significant attention is paid to the fact that our children have the ability to take advantage of the “stretch” and to defer payment of taxes on the inherited IRA as they draw the funds over time. As a tax tool, this certainly has a value. Yet the financial advisors almost never ask the question: Is your child in a risky profession, subject to current or future debt issues, or potentially under-insured?
It matters, and the discussion needs to take place.
When most of us think of such debt considerations, we may think of the under-insured motorist claim or the business loan guaranty signed personally by a shareholder. However, a thoughtful discussion should consider other very real concerns. How many of these scenarios raise your own awareness:
Your children’s student loans (or student loan guarantees they sign for your grandchildren)
Heavy credit card spending, subject to the high credit card interest rates
Medical debt and expected future medical expenses
Access to inherited IRA funds by a divorcing spouse after distribution
Family Expense Act obligations for debts of a spouse and children
Your child’s obligation for their own business debts and partnership obligations (partners are jointly and severally liable for debts of the partnership)
Tax obligations
Child support obligations (distribution from inherited IRA may be considered income)
Can the child simply file bankruptcy to avoid having the inherited IRA taken for their debts? No, the bankruptcy trustee, who is seeking to collect funds for distribution to the child’s creditors, is a “super creditor” and aside from other tools available to the trustee the inherited IRA is not protected from being taken during the child’s bankruptcy.
The use of an estate planning trust can help to protect the valuable inheritance you have worked so hard to make available for your children. Some attorneys recommend the use of a standalone Retirement Trust, while others recommend accomplishing the asset protection goals through modifications to the client’s living trust (often called an Estate Planning Trust or Revocable Trust).
Talk to your attorney. If you don’t have an attorney or your attorney is not familiar with these considerations, reach out to Attorney Marc Sherman https://mshermanlaw.com/contact/ to arrange for an estate planning review.
