Supreme Court Weakens Inherited IRA

The Supreme Court unanimously ruled in June that inherited IRAs are not protected in bankruptcy.

Since Individual Retirement Accounts (IRAs) were first created in 1974, they have been terrific savings vehicles. Contributions to traditional IRAs are tax-deductible and the assets grow on a tax-deferred basis until you draw the money out, as early as age 59 ½.

If you haven’t started pulling money out by 70 ½, the government requires you to pull money out on a schedule that starts out around 3.65 percent and grows over time (for a single person; Table III). The percent that you need to withdraw is based on your current age and your life expectancy. (See Publication 590 if you love details)

In 2006, the Pension Protection Act (PPA) created the ‘stretch’ or ‘inherited’ IRA that allows you to leave money to your heirs and the withdrawal rate is based on their life expectancy, which dramatically shrinks the percentage that your heirs need to withdraw.

For example, if you’re 75 years old (and, again, single in this example), the percentage of your IRA that must be distributed is 4.37 percent. The PPA allows you to leave the balance of the IRA to your heirs and the withdrawal rate is based on their life expectancy.

If the heir is 40, for example, the mandatory distribution rate drops to 2.29 percent, which allows more money to stay in the tax-deffered account for a longer period.

It’s a great tool for many people (consult with your estate planning attorney to see if it makes sense for you), but the high court determined that unlike regular IRA accounts, the inherited IRA doesn’t get the same protection.

Another way to say it is that it’s the same asset, but it’s protected when owned by the 70 year old, and unprotected when it goes to the heirs.

Ultimately, the court decided that because beneficiaries cannot add money to the accounts, can pull money out entirely at any time and are withdrawing some amount immediately, it didn’t qualify for the same protection as a regular IRA.

One area that isn’t completely clear is whether the bankruptcy protection is lost when the person inheriting the IRA is a spouse. Most experts seem to think that this ruling won’t apply, but it wasn’t specifically dealt with in the ruling, so it’s possible (although not likely) that the protection is gone for spouses.

Despite losing some protection, the inherited IRA is still a great strategy. It may make sense, however, to ask your estate lawyer whether or not your plan needs to be updated to reflect the the changes in the law, thanks to the ruling.