For Clients, Advisors and Community.  In March and May, 2011, I wrote blog articles about the asset protection aspects of inherited IRAs. This article describes current developments involving tax aspects of inherited IRAs. What is so important about inherited IRAs?

With careful planning, the beneficiary of an inherited IRA (typically a child) has the opportunity to defer income taxes (with tax-deferred growth) over his or her lifetime. Many refer to this as the “stretch IRA”. It is a significant income tax savings tool, particularly for individuals who have large IRAs, or for whom tax deferred monies constitute a large portion of their estate.

In some cases, without proper planning, the child or grandchild (and sometimes the spouse if the planning is done incorrectly) only has five years to withdraw all the money from the IRA. This is called the “five year rule”. This accelerates all the tax payment. The government gets its money at once. There is very little opportunity for tax-deferred growth.

The highway bill, which is currently moving through Congress, contained a provision removing the “stretch IRA” and implementing the five year rule for everyone. That would raise $4.6 billion over the next decade.

In recent weeks, there was an extensive campaign by members of the Financial Services Institute (your financial planners) which put extreme pressure on Congress, especially the Majority Leader of the Senate, Senator Harry Reid. Last week, Senator Reid removed the offending provision from the highway bill thereby leaving the current “stretch IRA” provisions in force.

The national experts in the field think that the Congress may revisit the matter. Who knows what is going to happen when the government is looking under every rock for revenue!

Strategy: If you or a family member is the beneficiary of an account or benefit in a profit sharing, 401(k), or pension plan where the employee has passed away, it will be important to do an inherited IRA rollover as soon as possible. You need to consult a financial planner or investment advisor who is familiar with the rules, as well as a tax attorney to ensure that the IRA is coordinated with your estate plan. The rules are complicated. You need to find individuals who are fully trained in the required minimum distribution (RMD) and trust rules.

Taxation of Inherited IRAs is one place the Congress may go looking for revenue. There is a possibility that the stretch IRA may become a thing of the past; I doubt it because there will be another uprising. Nonetheless, it makes sense to plan now.

For Clients, Advisors, Community

A recent published case emphasizes the importance of clients checking their beneficiary designations of their retirement plans including; profit sharing, 401(k) and pension — on a regular basis. The general rule is that if the participant is married, he or she must name his or her spouse as beneficiary (unless the spouse signs a waiver in the presence of a notary or a plan representative).  This law is to protect the interest of spouses.

Here is a good example of where problems with unchecked beneficiary designation can occur: After his first wife passed away, the plan participant named his three adult children as his plan beneficiaries.  Subsequently,
he remarried. He never changed the beneficiary on his plan accounts. His intent was that his three adult children become the beneficiaries of his retirement plan account. No spousal waiver was executed. Six weeks after he remarried, he died. His new wife and his three adult children both made claim for his 401(k) account balance.

The plan administrator filed suit asking the court for directions on who was the rightful beneficiary. The court awarded the account balance to his wife because no waiver had been signed. This was not the participant’s intention!

This litigation occurred in Federal District Court. These situations can be messy, cause family disharmony and are extremely expensive.

The lesson is clear: Double check your beneficiary designation on an annual basis. Make sure that it is properly coordinated with your estate plan and structured to defer income taxes as long as possible. This is a simple step. The retirement plan account is sometimes the largest asset in the estate.

We are increasingly finding the need to stay on top of these changing circumstances.  So, it makes sense to pay attention and review the plan every year.   We have developed a program which provides annual review and estate plan enhancement every that helps our clients ensure that these problems do not occur.

There are new techniques, particularly for larger plan benefits or IRAs which allow the family to “stretch” the benefits deferring taxes over an extended amount of time. We often discuss this topic with our clients during their annual estate plan enhancement meeting. For more information, call us.

For Clients, Professional Advisors

Since my March 3, 2011 posting on inherited IRAs, there has been an interesting precedent. A Federal Court in Texas has issued an important appellate decision. The case is Chilton v. Moser.

What happened? Shirley died in 2007 naming Janice as beneficiary of her $170,000 IRA. Janice opened an IRA titled, “Janice, beneficiary of Shirley IRA” and transferred the funds to this account. Janice filed a bankruptcy petition in December, 2008. Janice sought to protect the IRA from the bankruptcy estate, claiming that the assets were exempt from her creditors under Federal law. The United States Trustee objected. The bankruptcy court judge held that the assets were part of the bankruptcy estate and that they could be distributed to the creditors. Janice appealed to the Federal District Court.

In a well-reasoned appellate decision, Judge Ron Clark reversed the bankruptcy court decision. He held that in order for inherited IRA funds to be exempt from creditors in a bankruptcy (a) they must be tax exempt under §401 or §408 or §403 (or other) section of the Internal Revenue Code (covering individual retirement accounts, pension and profit sharing plans and certain non-profit organization annuity plans) and (b) they must be retirement funds.

The court went on to conclude that Shirley’s funds were both tax-exempt and were retirement funds. Therefore, the exemptions under the bankruptcy code applied and the money was in fact Janice’s. Her creditors in the bankruptcy case would be unable to reach them!

Can Illinois residents rely on these cases? The trend of the decisions is clear. All Federal District Court Decisions to date and one Appellate Court decision has been consistent with the holding in Chilton v. Moser.

However, one cannot say for certain that this is the law of the land. There is some likelihood that the Federal appellate courts will differ in how they apply the bankruptcy code to IRAs. Nationally respected IRA and tax expert Bob Keebler recommends that professionals continue to offer clients an individualized IRA trust for asset protection. It provides certain asset protection.

Until the matter is resolved by the Seventh Circuit Court of Appeals (Illinois, Wisconsin and Indiana), or if the circuits disagree, by the United States Supreme Court, we continue to offer our clients with large IRA accounts an individual retirement plan trust that provides the asset protection they need.

Why take a chance if a deal goes bad?

For Professional Advisors, Clients, Business Owners

Asset protection is an increasing focus in our practice.  In its March 4, 2011 Tax Letter, Kiplinger gave the impression that inherited IRAs are exempt from creditors and in bankruptcy, citing an Arizona case.  For now, that’s not the case in Illinois.  Allow me to explain:

In the case cited by Kiplinger, Kay Theim and her husband filed for bankruptcy.  While the bankruptcy was pending, Kay’s mother died, leaving her $10,032.57 as beneficiary of an IRA.  Mrs. Theim wanted to keep the IRA.  Who wouldn’t?  So, she amended her bankruptcy petition, seeking to have the inherited IRA exempted from her bankruptcy estate.  The bankruptcy trustee objected and the litigation progressed.  In a 21 page opinion, the United States Bankruptcy Court in Arizona held that the IRA was exempt and that Mrs. Theim could keep the IRA money.

What would happen if Mrs. Theim lived in Illinois?  Illinois has a statute that states that all IRAs and qualified retirement plans (401(k) plans, profit sharing plans, defined benefit plans) are exempt from attachment by creditors and are outside an individual’s bankruptcy estate. Meaning… One would hope that the beneficiary of an IRA would be awarded the same protections that an IRA accountholder would have. 

Unfortunately, in Illinois, Mrs. Theim might be out of luck.  A 2006 bankruptcy case, In re Taylor is the only case applying Illinois law.  The court summarily decided that a contributory IRA or rollover IRA and an inherited IRA were different because one cannot roll over an inherited IRA.  Thus, an inherited IRA is not the same as a contributory IRA and is not protected.  This ruling is controversial.  I’m certain it will be challenged in cases soon to come.

In the meantime, it will be important to consider asset protection planning for non-spouse inherited IRAs in Illinois.   This requires coordinated planning among the client’s professional advisors including his or her attorney, investment and/or insurance advisor and accountant. 

It’s 10:30pm as I write this.  Do you know if your inherited IRA is protected from creditor attack? 

Do you think that inherited IRAs should be exempt from creditors?

(Case and statute citations are available by contacting me).