Let me ask you a question. When your time on earth is over, who do you want to benefit from your estate? Who do you want to get the results of all your years of hard work, saving, and planning? Most people would probably choose family, and rightly so. But unless you do some advance planning, your heirs may not get as much of your estate as you want them to have. It’s possible the money you have in IRAs and 401(k)s could end up in the hands of your heirs’ creditors.
Generally, qualified retirement plans are exempt from bankruptcy claims. But that only applies to the original owner of the qualified plan. The exemption is not extended to people who inherit retirement funds.
In 2014, the U.S. Supreme Court ruled that inherited IRAs are fair game for creditors of the person who inherited the retirement money. In 2015, a bankruptcy court said that an individual who received interest in three retirement plans through a divorce decree could not protect that money from creditors.
It’s slightly different with inheriting a 401(k). A federal bankruptcy court heard arguments from a creditor claiming they could seize some of the funds in an inherited 401(k) just like they could in an inherited IRA to satisfy a debt. The court said no, stating that the assets had not been distributed from the 401(k) at the time of the bankruptcy proceedings and there were restrictions on what the beneficiary could do with the assets. If the court case had been heard later or the 401(k) funds had already been distributed to an IRA, the money probably would not have been protected.
CPA and attorney Bob Carlson points out that laws governing inherited IRAs and inherited 401(k)s are still developing and recent decisions could be overturned or appealed. He says,
- These cases that have been heard involve federal bankruptcy law.
- States which have their own bankruptcy laws may provide more protection to inherited retirement accounts than federal laws.
- The cases involve beneficiaries who were not spouses of the original account owners. (Spouses have more protection when they inherit retirement funds.)
Knowing all this, take it into consideration when doing your estate planning. If you have an heir(s) who has problems with creditors, you may want to choose other parts of your estate to leave them rather than IRA or 401(k) funds. Consider whether you want to leave those heirs non-retirement funds or put their inheritance in a trust for them. As part of your planning, you might even change the beneficiaries on those retirement accounts. It doesn’t matter who you’ve listed as beneficiaries in your Will or Trust. It’s the beneficiary form on file at the time you die that decides who inherits the retirement money.
This article is for information purposes only and should not be considered tax, legal or financial advice.