Don’t let your heir’s creditors end up with your retirement funds

As part of your estate plan, you need to determine whether it is possible for your IRA or 401 (k) to end up in the hands of the creditors of one of your heirs.

A general rule of thumb is that qualifying retirement plans are exempt from bankruptcy claims. But this general rule only applies to the original owner of the account. Beyond that, the situation is murky. The results may depend on whether the account is an IRA or 401 (k) and whether federal or state law applies.

In 2014, the United States Supreme Court ruled that an inherited IRA can be seized by the payee’s creditors. While federal bankruptcy law protects an original owner’s IRA from the owner’s creditors up to a certain value, this protection does not apply to a beneficiary. Once an IRA is inherited, the retirement account exemption under federal bankruptcy law does not apply.

In a 2015 bankruptcy case, the court ruled that a person who received interest in three pension plans through divorce also could not protect those accounts from creditors.

This year, a federal bankruptcy court considered whether an inherited 401 (k) could be paid to the creditors of the bankruptcy beneficiary. Under federal bankruptcy law, an employer pension plan such as 401 (k) generally receives more protection than an IRA.

In this case, the assets were still in the 401 (k) plan when the bankruptcy proceedings were conducted. Later, the 401 (k) administrator distributed the assets to an IRA established for the beneficiary. The creditors learned about this and argued that they should be able to claim the IRA to pay off the debts.

The court disagreed. The assets had not been distributed from the 401 (k) plan at the time of the bankruptcy proceedings, and there were legal restrictions preventing them from being distributed at that time. There were also restrictions on what the grantee could do with the 401 (k) assets.

If the bankruptcy proceedings had taken place at a later date or if the 401 (k) had been distributed to the IRA earlier, the money probably would not have been protected. But in this case, the creditors did not have access to the money.

There are a few important points to keep in mind.

The law is not fully developed in this area. Recent decisions could be appealed and overturned. Or other courts in the future might rule differently.

In addition, these cases concern federal bankruptcy law. States have their own bankruptcy laws, and many of them offer retirement accounts more protection than federal law. The results may be different when bankruptcy actions fall under state law instead of federal law.

These cases also involve beneficiaries who were not the spouses of the original account holders. Spouses benefit from greater protection when a retirement account is inherited.

When your beneficiary is likely to have issues with creditors, this is a factor to consider when making decisions such as whether to leave money in a 401 (k) plan or transfer it to a IRA. It can also affect who is named the beneficiary of your retirement accounts and whether you want to leave assets directly to someone or in trust. Discuss the details and compromises with your estate planning lawyer.

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