Planning to Protect Inherited IRAsTuesday, October 18, 2016
When planning for retirement, many people have relied in the past on their company’s pension plan or savings plan to provide them with additional income to supplement their Social Security payments. Over the past decade, we have seen a decline in the use of a pension plan to provide retirement income, and many companies have even terminated their pension plans altogether. During periods of economic downturns, many people cut back on their contributions to a company savings plan or even choose to not contribute for one or more years. Whether or not they are planning on using a company pension plan at retirement age, many of our clients own one or more individual retirement accounts to better secure their future.
An individual retirement account, or IRA, may fall into one of three basic types of retirement accounts: the Traditional IRA, the Roth IRA, and the Inherited IRA. Most people are familiar with the Traditional IRA since this type has been around for a long time. For the traditional IRA, there is a limit on contributions, which are tax deductible and accumulate on a tax-free basis. However, once distributions can be received at retirement age, they are taxable.
A Roth IRA came into existence around 1998. Although contributions are not tax-deductible, income and growth still accumulate on a tax-free basis, and distributions are not taxable when received.
An Inherited IRA, sometimes referred to as the “Stretch IRA”, came into existence around 2003 and is an individual retirement account that is acquired by a person from an individual who has died. The recipient may extend (or stretch) the distributions from such an account over his or her lifetime and thereby extend the period of time within which to pay income taxes on the distributions.
Inherited IRAs are often helpful to people, however owning one can also get complicated when financial situations take a turn. It has long been presumed that if a person files for bankruptcy, their retirement accounts (including assets held in an IRA) would be entitled to bankruptcy protection. Only the first $1,000,000 of “retirement funds” is exempted, adjusted for inflation. For 2016, this protection is now $1,283,025.
Due to several cases brought to the Bankruptcy Court in recent years, the exemption for Traditional IRAs and Roth IRAs will remain the same, since they are “sums of money set aside for the day an individual stops working”. Furthermore, such accounts impose early withdrawal penalties if monies are withdrawn prior to age 59½, which is another indication that the accounts are not to be spent until retirement. An Inherited IRA, on the other hand, represents a windfall to the recipient who did not contribute to such an account for retirement. In fact, no contributions to an Inherited IRA are permitted under the Internal Revenue Code and the entire balance may be withdrawn at any time without incurring any early withdrawal penalty. The United States Supreme Court in 2014 ultimately ruled that Inherited IRAs are not retirement funds, because the funds were not specifically set aside by an individual to secure a financially comfortable life after retirement.