Most of my clients have a large percentage of their wealth in IRAs. Although these accounts were intended to help pay for retirement, many people never take out more than the required distributions. This means that their spouses, children, or other loved ones end up inheriting the IRA. Inherited IRAs are different from other assets that are inherited and from other IRAs.
Most inherited assets, such as life insurance, real estate, and vehicles, are not counted as income. However, the funds in inherited IRAs have not yet been taxed. Therefore, any amounts withdrawn from non-Roth accounts are subject to income tax at the beneficiary’s ordinary income tax rate.
A surviving spouse can roll over an IRA into his or her IRA. However, for other beneficiaries, inherited IRAs are different from other IRAs in several ways. Unlike the beneficiary’s retirement accounts, he or she cannot add funds to an inherited IRA. The beneficiary will also have to take required minimum distributions, no matter his or her age. For regular IRAs, required minimum distributions do not start until age 70 ½. Most inherited IRAs can be stretched out over the life expectancy of the beneficiary. This allows continued tax-deferred growth in the account. And while there are penalties for early withdrawal from a regular IRA, funds from inherited IRAs can be withdrawn at any time.
Many people name their spouse as their primary beneficiary and then designate their children or other individuals as contingent beneficiaries. While this approach will usually avoid probate and preserve the stretch out, it provides limited preservation or protection for the inherited accounts.
In a major decision last June, the U.S. Supreme Court, in Clark v. Rameker, ruled that inherited IRAs are not considered protected “retirement funds”—and are thus subject to creditors’ claims if the beneficiary files for bankruptcy. Regular IRAs are protected from bankruptcy. Part of the rationale for protecting IRAs is that there are penalties for early withdrawal. This does not apply to inherited IRAs. The owner of an inherited IRA may withdraw the funds at any time without penalty. The Supreme Court characterized inherited IRAs as a “pot of money that can be used for current consumption.” Fortunately, North Carolina law protects inherited IRAs from creditors. However, if your beneficiary moves out of North Carolina, those protections may be lost. Only approximately eight states have similar statutory protections.
Even if the inherited IRA is protected from creditors, it is not protected from the beneficiary. Remember that the “pot of money” that you worked for can be used by your beneficiaries for “immediate consumption.” While you may think it is a fine idea for your beneficiary to cash in an inherited IRA to buy a home, you may not feel the same way about a new Corvette.
It sometimes makes sense to leave a retirement account to a carefully-designed trust. Retirement trusts are specifically designed to receive retirement account balances, allow the account to continue growing on a tax-deferred basis for as long as possible, protect the IRA from the beneficiary’s creditors, and allow for distribution in accordance with your wishes.