Individual retirement arrangements can be established in either of two legal forms: a custodial account (Internal Revenue Code §408(h)); or a trusteed IRA (§408(a)). Both are treated identically for tax purposes. Most IRAs are established as custodial accounts rather than trusts. This article deals with using a trust as a conduit for a beneficiary of an IRA or other retirement plan, in place of a standard custodial IRA, payable to a beneficiary. A Roth IRA can also be in the form of a trusteed IRA. A trusteed IRA is also known as an individual retirement trust (IRT).
What is an Inherited IRA?
An Inherited IRA is a traditional or Roth IRA that has been inherited after its owner’s death. See IRC §§408(d)(3)(C)(ii) and 408A(a). If the heir is the owner’s spouse, as is often the case, the spouse has a choice: He or she may “roll over” the IRA funds into his or her own IRA, or keep the IRA as an inherited IRA. When anyone other than the owner’s spouse inherits the IRA, he or she cannot roll over the funds; the only option is to hold the IRA as an inherited IRA.
Inherited IRAs do not operate like ordinary IRAs. Unlike with a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time, without paying a tax penalty. IRC §72(t)(2)(A)(ii). Moreover, the owner of an inherited IRA not only may but must withdraw its funds: The owner must either withdraw the entire balance in the account within five years of the original owner’s death or take minimum distributions on an annual basis. See IRC §§408(a)(6) and 401(a)(9)(B); 26 CFR 1.408-8 (2013) (Q-1 and A-1(a) incorporating §1.401(a)(9)-3 (Q-1 and A-1(a)). And unlike with a traditional or Roth IRA, the owner of an inherited IRA may never make contributions to the account. 26 U.S.C. 219(d)(4).
Why consider a trusteed IRA? The United States Supreme Court in June of this year decided Clark v. Rameker, 134 S.Ct. 2242 (2014). There, the court determined that funds held in an unmarried taxpayer’s Chapter 7 debtor’s inherited IRA did not qualify as “retirement funds” for purposes of 11 U.S.C. §522(b)(3)(C)’s bankruptcy exemption. In doing so, the court held that: “Retirement funds were sums of money set aside for the day an individual stops working,” and noting that, unlike holders of traditional or Roth “quintessential retirement accounts,” inherited IRA holders were prohibited from investing additional money in their accounts, were required to make withdrawals regardless of how many years away from retirement they were, and were in fact entitled to withdraw the entire balance at any time for any purpose without facing tax penalty. The court concluded that inherited IRA funds constituted a “pot of money” freely available for current consumption rather than retirement funds. The court also looked at the Bankruptcy Code’s careful balancing of exemptions between both debtor and creditor interests and fresh start purposes to bolster its conclusion, noting that foregoing would be converted and debtors would essentially be given “free pass” if allowed exemption for an inherited IRA.
Because of the distinct difference between a traditional IRA and an inherited IRA, the Supreme Court concluded that the funds held in such accounts are not objectively set aside for purposes of retirement. Therefore, the inherited IRA is not entitled to the exemption from retirement funds of 11 U.S.C. 22(b)(3)(c).
In doing so, it determined that the inherited IRA bore little resemblance to the traditional IRA’s legal characteristics, and said inherited IRAs constituted “a pot of money that can be freely used for current consumption.” 714 F.3d at 561, not funds objectively set aside for one’s retirement. The court went on to say that allowing debtors to protect funds held in traditional IRAs and Roth IRAs met with the purpose of ensuring a debtor meets basic needs during retirement. To allow the same exemption to an inherited IRA from a bankruptcy estate, gives a “free pass” to these funds; citing Schwab v. U.S., 560 U.S. 770, 791 (2010).
New Jersey is one of 43 states that provide an exemption for traditional IRAs, and one of 41 that provide an exemption for Roth IRAs. See N.J.S.A. 25:2(b), except for tortious killing, child support and fraudulent conveyances. Most other states provide protection but often limit their protection to a dollar amount or “reasonable needs.”
Notable exceptions that provide no exception include California, Minnesota, Georgia, Nebraska, Nevada, and North and South Dakota.
Specifically, New Jersey’s statute provides protection to “qualifying trusts” created and maintained pursuant to federal law, including but not limited to, sections 401, 403, 408, 408A, 409, 529 or 530 of the IRC. In Gilchinsky v. National Westminster Bank, 159 N.J. 463 (1999), the New Jersey Supreme Court addressed the state law exception for IRAs from the reach of creditors. The court noted that:
N.J.S.A. 25:2-1 provides a “qualified immunity” for funds deposited in a New Jersey IRA. The purpose behind such expansive protection is to prevent creditors from attaching money earmarked for retirement. That immunity, however, is not absolute. N.J.S.A. 25:2-1(b). Creditors can attach funds transferred into an IRA in “preference” of other creditors, as a “fraudulent conveyance,” or if the money is subject to a support order. N.J.S.A. 25:2-1(b); C.P., supra, 293 N.J. Super. at 437-38, 681 A. 2d 105; Assembly Financial Institutions Comm. Statement to Assembly Comm. Substitute for Assembly, Nos. 288 and 1462 (Sept. 14, 1992). In exempting fraudulent conveyances from the otherwise broad-based immunity, the Legislature clearly intended to prevent debtors from using New Jersey law to shield their assets from creditors.
The Gilchinsky case dealt with an individual who rolled over funds from his New York qualified plan to a New Jersey IRA, ostensibly to avoid creditors. The court noted that when he did so he lost the “blanket” protection afforded by ERISA and became subject to New Jersey law.
It remains to be seen whether an inherited IRA will be given the protection from creditors under New Jersey law. Much like the United States Supreme Court in Clark, the language of the New Jersey Supreme Court in Gilchinsky would seem to deny protection as it interpreted the rationale of our statute to provide protection from creditors for funds earmarked for retirement in a similar fashion as Clark.
As noted above, an IRA can be established either as a custodial IRA or as a trusteed IRA. The form usually selected by most participants is the custodial IRA. The trusteed IRA, although not new, has taken on greater significance even where “qualified plans” are protected. Certainly in those states that afford no protection or little protection, a custodial IRA is a “pot of money” that can be reached by creditors. In New Jersey, while statutory protection is provided to retirement funds, the Clark case reasoning seriously questions whether an inherited IRA will be protected under New Jersey law.
Trusteed IRAs combine the tax advantage of an IRA with the flexibility and control of a trust. The trusteed IRA can be used where:
The grantor wants to control who receives his IRA assets, what amounts and when;
The grantor may be concerned about the capacity of the IRA beneficiary;
The grantor wants to extend the tax deferral of the IRA for his children, grandchildren or heirs;
The grantor has remarried and wants to provide for his new spouse, yet ensure his IRA assets will pass to his children;
The grantor wants continuity of management of the funds, especially where the grantor is concerned about the ability of his heirs to manage the funds.
The trusteed IRA can be used for a 401(k), 403(b) and SEP as well. In short, like most other trusts, the trusteed IRA can be crafted to meet the needs and expectations of the grantor and provide protection from creditors, which trusts normally provide.
As a reaction to the Clark decision, seven states enacted legislation protecting nonspousal IRAs. These include: Alaska, Arizona, Florida, Missouri, North Carolina, Ohio and Texas.
A trusteed IRA is an ideal vehicle for protecting an inherited IRA. As discussed above, protection from creditors differs from state to state or is nonexistent. Hence, no matter where the beneficiary may reside, the IRA assets in the trust will be protected from creditors.
Additionally, in light of the Clark decision, the trusteed IRA will make the basis upon which Clark was decided inapplicable.
Consulting an experienced estate planner and working with a qualified financial professional is essential for one to meet the goals of providing for heirs and protecting retirement assets from creditors once they are converted into inherited IRAs. •