An inherited IRA, unlike a regular IRA, may not be exempt from creditor attack under the laws of some states. The reason is in the difference between an inherited IRA and a regular IRA: in a regular IRA funds were contributed by the owner; and in an inherited IRA a beneficiary may make no contributions into the account, nor may he or she roll over the inherited individual retirement account into another retirement plan. Illinois law makes no distinction between the protection afforded to a regular IRA and an inherited IRA.
A surviving spouse is almost always advised to roll over an IRA inherited from his or her spouse into his or her own IRA, which is always asset-protected. Further, the spouse follows the normal withdrawal requirements for his or her own IRA. A surviving spouse could retitle an IRA as an inherited IRA as such, but then he or she would be required to take distributions each year just as any other IRA beneficiary would be required to do, and, depending upon the applicable state’s law, may also not be able to asset-protect the IRA.
When we speak of an “inherited IRA” we are referring to an IRA inherited by a non-spouse beneficiary. Because it may not be asset-protected, when a non-spouse beneficiary inherits an IRA outright it is subject to the claims of the beneficiary’s creditors, or to the claims of a beneficiary’s spouse in a divorce, or dissipation as a result of reckless spending by a beneficiary, thereby negating opportunity for tax-free appreciation over the life of the non-spouse beneficiary.
Anyone who owns an IRA and is contemplating leaving the IRA to a non-spouse beneficiary, with the expectation that the non-spouse beneficiary will stretch out required minimum annual distributions over his or her life without depletion as a result of creditor’s claims or an award in a divorce proceeding or reckless spending by a beneficiary, should consider leaving the IRA to a IRA stand-alone trust for the benefit of the beneficiary and designated successor beneficiaries in future generations.
In a recent private letter ruling, the IRS sanctioned a specially structured form of trust that is designed to spread out the required minimum distributions over the life of the beneficiary and still retain the benefits of spendthrift protection.
The strategy requires the creation by the owner of the IRA of a revocable trust dedicated solely to be the beneficiary of the IRA. This trust is, at the discretion of the owner of the IRA, either a conduit trust, meaning the trustee will distribute the minimum required distribution annually to the beneficiary, or it is a accumulation trust, meaning income is distributed in the sole discretion of the trustee.
This revocable trust becomes irrevocable upon the death of the grantor. As an irrevocable trust, the principal of the IRA is not subject to the claims of the non-spouse beneficiary’s creditors or spouse in the event of a divorce. As such, this inherited IRA is now asset-protected.
IRAs are becoming a more significant asset in most wealth plans. Please do not hesitate to contact us if you have any questions about providing asset protection for non-spouse beneficiaries who may inherit your IRA.