Inherited IRAs aren’t protected from creditors

If you’re planning to leave an IRA or other retirement account to your heirs, you might want to consider creating a trust to hold the account. That’s the upshot of a recent ruling from the U.S. Supreme Court. That’s because IRAs that are inherited from anyone other than a spouse are no longer protected from creditors in a bankruptcy.

Heidi Heffron-Clark and her husband Brandon filed for bankruptcy after their pizza shop failed in 2009. They owed their landlord $74,000, but didn’t have enough cash on hand to pay the debt. Heidi did, however, have $293,000 in an IRA that she inherited from her mother.

In general, IRA funds are exempt from creditors in a bankruptcy. Congress created this rule in order to protect Americans’ retirement savings and to prevent elderly people from not having enough to live on.

But the Supreme Court made an exception, and said this rule doesn’t apply to inherited IRAs – at least if they were inherited from someone other than a spouse. Inherited IRAs are different, the court said, because the owner didn’t actually contribute any funds to them, and simply received them as a kind of windfall. Therefore, Heidi’s IRA could be tapped to pay off the landlord.

As a result, if you’re planning to leave an IRA to your children or other heirs, and you want to protect the funds in case your heirs rack up business or personal debts or get sued in a lawsuit, you might want to leave the IRA to a trust instead.

A trust might not be absolutely foolproof, but it provides much better protection than simply leaving an IRA to someone directly. Although the Supreme Court case involved an IRA, the same principle might well apply to other sorts of retirement plans such as 401(k) and 403(b) plans.