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Using a Creditor-Proof IRA Trust to Protect Your Beneficiaries

March 2010

An IRA trust is the only sure bet when it comes to protecting inherited IRAs

The combination of tax deferral and asset protection is a potent, long-term legal and financial strategy. Whether IRAs and other retirement plans are exempt from the claims of creditors of the IRA's owner varies from state to state. In Arizona, IRAs are generally exempt from such claims.

But does the same protection apply to IRAs that are inherited? If an original owner dies, and the IRA is not liquidated but instead is inherited by the beneficiary, will the IRA be protected from the claims of the beneficiary's creditors? In Arizona, the answer is “yes.”

However, what if the beneficiary lives in a state other than Arizona when the inheritance occurs? This can be a significant concern for an owner of an IRA – such as a parent or grandparent – who wants to leave the IRA to a beneficiary but is worried that it may be seized by a creditor. The key variable: How do the laws of the state where the beneficiary lives at the time he or she inherits the IRA address this issue?

In a Florida case, Robertson v. Deeb, the court decided that inherited IRAs are not protected from creditor claims. The court reasoned that the IRA exemption applied only to the original owner and did not extend to the beneficiary.

Texas bankruptcy courts reached the same conclusion in In re Jarboe. In that case, Mom died leaving her IRA to Son. Several years later, Son filed for bankruptcy and claimed that the IRA was exempt under the state property code. The bankruptcy trustee argued that the inherited IRA was not exempt, and the court agreed.

Conversely, in a recent Minnesota case (In re: Nessa), the bankruptcy court ruled that an inherited IRA was protected. The key difference in this decision is that Minnesota adopted the federal property exemptions from bankruptcy law, whereas Florida and Texas used state exemptions.

So, even though Arizona protects the beneficiary of an inherited IRA, your children or grandchildren might one day move to a state (such as Texas or Florida) that does not.

Solution: an IRA Trust. Don't take chances with your hard-earned retirement money. Our general recommendation is to leave IRAs to beneficiaries in a stand-alone IRA trust to ensure maximum protection from creditors.

Why use a stand-alone trust and not your living trust? For a trust to be a “designated beneficiary” for IRA and retirement plan purposes, very complex rules must be strictly followed. Failure to follow those rules can result in disastrous unintended consequences. Most living trusts simply are not set up correctly to meet the “designated beneficiary” definition. Make sure your living trust is carefully reviewed, and amended if necessary, if you are thinking of naming it as a beneficiary of an IRA or other retirement plan.

If you die without establishing a stand-alone IRA trust, there may still be other options available. For example, a beneficiary who receives an IRA from anyone other than a spouse and is concerned about the IRA’s exposure to creditors may wish to reinvest the proceeds in exempt assets such as homestead property or life insurance.

However, whether a particular kind of asset is exempt from the claims of creditors is determined, again, on a state-by-state basis. As a result, the stand-alone IRA trust is the only sure bet when it comes to protecting inherited IRAs.

Adapted from the Daily Plan-It newsletter.

Hoopes, Adams & Alexander, PLC, is a Chandler, Arizona, law firm offering services to Phoenix-area clients in the areas of estate planning, entity formation, commercial and real estate transactions, and civil litigation.