This summer, the Supreme Court of the United States ruled unanimously that inherited IRAs are NOT retirement accounts, and it is now the law of the land. To learn more about why your IRA may not be a retirement account and what it means for you, read on.
First, some background
An "inherited IRA" is one you received because you were listed as a beneficiary on someone else's IRA or retirement plan. Since the "R" in IRA stands for RETIREMENT, it would be easy to assume that all IRAs are retirement accounts. In fact, that's what the financial services industry has always assumed - until now.
Clark v Rameker
In the case of Clark v. Rameker, the SCOTUS ruled that inherited IRAs are NOT retirement accounts for the following reasons:
Beneficiaries cannot add money to inherited IRAs like they can to other retirement accounts.
Inherited IRA beneficiaries must begin taking distributions the year after they inherit the account -- even if they are not anywhere near retirement age.
Inherited IRA beneficiaries may take distributions prior to age 59 and a half without any penalties.
While this ruling applies specifically to inherited IRAs, it is unclear if it applies only to IRAs inherited by a non-spouse beneficiary (child, grandchild, etc.) or if it also includes IRAs that pass to a surviving spouse. According to the technical advisors at Ed Slott's Elite IRA Group, it's unlikely that the new ruling would apply to spouses and even if it did, spouses have the right to roll the IRA they inherited from a deceased spouse into their own IRA.
Clark v Rameker was specifically referring to a situation in which Heidi Heffron-Clark filed for Chapter 7 bankruptcy protection and argued that her $300,000 inherited IRA was an exempt asset because it was a retirement account. Her creditors, the Wisconsin bankruptcy court and the United States Supreme Court disagreed.
The case was decided on June 12, 2014, it's impact on who you chose as your IRA or retirement plan beneficiary may have been felt immediately by some. If the beneficiary is someone other than your spouse, the court has ruled that those assets could be subject to creditors in a bankruptcy. Presumably this would also include cases in which the IRA beneficiary was sued for financial damages in civil court. In either case, if your beneficiary is vulnerable to creditors or a law suit you may want to rethink your beneficiary designation or consider other alternatives.
While the SCOTUS decision answered the question "Is an inherited IRA a retirement account?" it raised others. The first two questions that popped into my mind are "Who pays the tax on my inherited IRA if I am sued?" and "How does this affect my college student's financial aid?"
All IRA distributions are taxable regardless of the reason for the distribution. If you inherit an IRA worth $100,000 and lose it to a creditor, you not only lose the IRA but you will have to pay tax on the entire $100,000 as well.
The financial aid question is less clear. According to Lynn O'Shaugnessy, author of the book The College Solution and blog of the same name, it's unlikely that the FAFSA form will be affected by this decision. IRAs of all types will most likely still be counted as retirement assets. Students and parents who fill out the PROFILE form at some private colleges may have a different experience. Since each private school can determine their own policy, parents would be wise to ask how the schools they are considering view inherited IRAs and what that may mean for the student's financial aid award.
IRA planning, staying on top of the latest rules and regulations, and establishing the right beneficiary designation has never been more important. The Supreme Court decision to redefine some of your retirement accounts only illustrates that point.
For answers to your IRA and retirement planning questions, just ASK MIKE.
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