In Clark v. Rameker, the United States Supreme Court held that an inherited IRA does not fall within the definition of retirement funds under Federal Bankruptcy law and is, therefore, not exempt from claims in a bankruptcy proceeding. This decision had a considerable impact upon the estate planning world.
It has long been the law that IRA or other retirement accounts, as defined in 11 U.S.C. § 522(b)(3)(C) are exempt from the reach of a bankruptcy trustee. In the Clark decision, the Court was called upon to decide whether funds contained an inherited Individual Retirement Account (“IRA”) qualify as retirement funds “within the meaning of the bankruptcy exemption”. The Court found that an inherited IRA does not qualify for the bankruptcy exemption. In making its decision, the Court identified three independent characteristics which differentiate an IRA from an inherited IRA. Unlike traditional IRAs or Roth IRAs, where one can make an additional contribution to the IRA, the owner/beneficiary of an inherited IRA may never invest additional money in the account. Secondly, an individual owner of an inherited IRA is required to make mandatory required distributions from the account annually beginning in the year after the deceased owner’s death, based upon the life expectancy of the individual who has inherited the IRA account. This is in direct contrast to the owner of a traditional IRA who must withdraw funds without penalty only when he or she is close to retirement age, i.e. age 59 ½. Thirdly, the Court noted that one who has inherited an IRA account may withdraw the entire balance at any time and for any purpose without penalty. The owner of a traditional IRA or other retirement account will pay a ten percent (10%) penalty, subject to some very narrow exceptions, if he withdraws prior to age 59 ½. For these reasons, the Court held that an inherited IRA may not benefit from the protection afforded to the owner or participant in a traditional retirement account.
Interestingly, in New Jersey, however, it has been determined that an inherited IRA constitutes a “qualifying trust” under N.J.S.A. 25:2-1(b) and as such will be excluded from a debtor’s bankruptcy estate. In Re: Andolino, 525B.R.588. The New Jersey Bankruptcy Court found that the language of the New Jersey Statutes exempts the inherited IRA from the bankrupt’s estate. In that regard, N.J.S.A. § 25:2-1(b) provides that “any property held in a qualifying trust and any distributions from a qualifying trust, regardless of the distribution plan elected for the qualified trust, shall be exempt from all claims of creditors and shall be excluded from the estate in bankruptcy”. Id. A “qualifying trust” refers to a trust “created or qualified and maintained pursuant to Federal law, including but not limited to § 408 of the Internal Revenue Code of 1986. The Bankruptcy Court in New Jersey noted that the IRA’s “status as a qualifying trust remains unchanged, notwithstanding the debtor’s receipt of the IRA as a beneficiary”. Andolino supra, at 591.
Therefore, while there is protection afforded to a New Jersey beneficiary of an inherited IRA, one must acknowledge that in today’s mobile society, a debtor who may be protected under New Jersey may move to another state, such as Wisconsin, which excludes the inherited IRA from protection from the Bankruptcy Court. Therefore, if the owner of an IRA has concerns about the ability of a creditor to obtain control over the inherited IRA account, then the recommended course of action is to make the proceeds payable to a trust for the benefit of the beneficiary.
While an outright distribution to the spouse is most often the preferred designation, there are many instances when a trust to hold and administer IRA benefits will be advisable: to assure that on the death of the second spouse, the balance of the account will pass to the original participant’s descendants; to mandate that a child take advantage of the ability to stretch out payments and defer income tax over the beneficiary’s lifetime; to protect the beneficiary against his own imprudence; to mandate professional management of the fund; to avoid estate tax on the beneficiary’s death; and to plan properly for a special needs beneficiary.
The impact of the Clark decision is, moreover, even in New Jersey, significant for those beneficiaries who might not otherwise need a trust. Typically, when planning for the benefit of a spouse, the routine recommendation is that the spouse be named as the primary beneficiary so that on the participant’s death the surviving spouse can roll the IRA over into his or her own IRA. In some cases, however, especially where the surviving spouse is younger, it can sometimes make sense for the surviving spouse to treat that IRA as an inherited IRA so that the surviving spouse can begin to make withdrawals even if he or she has not attained age 59 ½. Given the Court’s decision in Clark v. Rameker, this approach of treating the IRA as an inherited IRA for the benefit of the surviving spouse is problematic. Similarly, it has been suggested that the Clark decision raises a question as to whether or not even a surviving spouse who has rolled over the IRA to his or her name can be assured that the IRA is protected from his or her creditors.
Once a decision is made to make the IRA payable to a trust, the trust must meet certain requirements. The discussion of all of those requirements is beyond the scope of this article. One requirement, however, that is of concern to us is that the beneficiaries be “identifiable”, so that the custodian can identify the relevant life expectancies that will apply to the trust. Typically, trusts which hold IRA accounts will be either a conduit trust or an accumulation trust. In a conduit trust, the trustee is directed to withdraw from the IRA, the minimum required distribution, and deposit it into the trust account and then make the payment of that minimum required distribution amount to the beneficiary of the trust. In many cases, such as the case of the trust for a surviving spouse or an otherwise competent child the mandatory pass-through component of the conduit trust will work.
Trusts for the benefit of special needs beneficiaries or minors, however, would suffer from this kind of provision because a payment out to a special needs beneficiary or a minor child would often be inadvisable. In the case of a special needs beneficiary, we must be mindful of the need to avoid the beneficiary’s disqualification from receipt of valuable financial government benefits in the event he or she is the owner of an inherited IRA account. In that case, language must be included in the trust which will guaranty that the life expectancy of the special needs beneficiary will be applied even though the annual mandatory required distributions are not made directly to the beneficiary. As such, the trust agreement must direct that no one who is older than the special needs beneficiary may be a remainder or contingent beneficiary of the trust. In some cases this presents a workable resolution. In other cases, it can be a challenge. In any event, the focus when dealing with the payment of IRA benefits must be that the custodian of the IRA account can identify the life expectancy of the relevant beneficiary. As such, the rules applicable to a trust which is intended to receive IRA benefits over the life of the beneficiary are strict and complex. The significant amount of wealth contained in retirement accounts in this country coupled with the income tax burdens applicable to such accounts and the ever expanding needs for trusts make planning in this area a necessity.