For those of you out there who believe that the IRA you inherited from your parents is protected from creditors, litigators, and divorce, you may be having a rough awakening. Regarding creditor protection for inheritance IRAs, the Florida Supreme Court recently ruled that debtor inheritance IRAs may not be protected from creditor claims under Florida law. This can substantially affect how you structure your inheritance IRA and other tax-eligible plans.
When someone dies, the IRA custodian gives the IRA beneficiary two options. The first option is to transfer the initial IRA to an inherited IRA, which requires the recipient to take a minimum distribution based on his life expectancy and allows him to withdraw additional amounts without penalty. This allows for expansion of IRA distributions and upfront tax restrictions.
The second option offered to beneficiaries is to deposit the IRA in the deceased person’s account and allow the beneficiary to take monthly distributions for five years. This second option requires the beneficiary to empty the IRA account faster but also provides him with instant asset protection for that five-year period, protecting inheritance from creditors, divorce, and any judgment liens against the beneficiary. At least, that’s what we believe to be the truth.
According to Florida Statute Section 222.21(2)(a), any “money or other asset paid to the owner, participant, or beneficiary of, or any interest of the owner, participant, or beneficiary in, funds or accounts is exempt from all creditor claims from owners, beneficiaries, or participants if the funds or accounts” are retained as an IRA. The same goes for ERISA plans, DROP plans, Retirement plans, and annuities. (Note: Life insurance and home investment also provide instant asset protection but are not related to this discussion.)
Despite the simple wording of the law, the Florida Supreme Court recently concluded that Section 222.21(2)(a) does not apply to inherited IRAs because they claim that the law only refers to original IRA funds and that inherited IRAs are taxed differently, which makes them completely separate from the original account. The Court’s argument was that an inherited IRA is a separate account created when the original account is passed on to the beneficiary after the death of the original owner.
While the Court’s argument was that the IRA’s tax-exempt status changed because the beneficiary was obliged to take distributions, the Court overlooked the fact that the original owner of the IRA would be forced to take the minimum distribution starting at age 70½ if he or she were still alive. The court clearly missed the boat with this ruling, but that doesn’t change the fact that asset protection attorneys must now take this ruling into account when preparing and implementing an asset protection plan.
Courts have been inconsistent regarding the protection of inherited IRA assets. Because of this inconsistency, our company recommends to our clients that the initial owner of the IRA create a living trust as part of a comprehensive real estate plan. The beneficiary of an IRA must be the owner’s trust. An irrevocable hereditary trust is then created and funded upon the death of the original owner. At that time, all proceeds from the IRA are fully protected by the beneficiary’s trust, but are fully accessible to the beneficiary.
This whole process can be very confusing but with IRA assets becoming an increasingly significant part of many client estates, in situations where creditor protection for client beneficiaries is a concern, we all need to be made aware of the potential asset protection issues an inherited IRA presents.
Warning: You should always consult a professional when creating and enforcing an asset protection plan. Asset protection attorneys are trained specialists who can ensure that a plan is put in place to protect without the risk of being deemed fraudulent.
