For those of you who believed that the IRA you inherited from your parents is protected from creditors, litigants, and divorce, you may be in for a rude awakening. With respect to creditor protection for inherited IRAs, the Florida Supreme Court recently ruled that a debtor’s inherited IRA cannot be protected from creditor claims under Florida law. This can substantially affect how you structure the inheritance of your IRAs and other tax-qualified plans.
When a person dies, the IRA custodian gives the IRA beneficiary two options. The first option is to roll over the initial IRA to an inherited IRA, which requires the beneficiary to take minimum distributions based on his or her life expectancy and allows the beneficiary to withdraw additional amounts without penalty. This allows you to spread out IRA distributions and limit taxes up front.
The second option offered to the beneficiary is to keep 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 faster, but it also provides instant asset protection during that five-year period, protecting inheritance from creditors, divorce, and any court liens against the beneficiary. At least, that’s what we believed to be the truth.
Pursuant to Section 222.21(2)(a), Florida Statutes, any “money or other assets payable to an owner, participant, or beneficiary of, or any interest of any owner, participant, or beneficiary in a fund or account is exempt from all claims of the owner’s, beneficiary’s or participant’s creditors if the fund or account” is held as an IRA. The same is true for ERISA plans, DROP plans, pension plans, and annuities. (Note: Investments in life and home insurance also provide instant asset protection, but are not relevant to this discussion.)
Despite the simple wording of the statute, the Florida Supreme Court recently concluded that Section 222.21(2)(a) does not apply to inherited IRAs because they assert that the statute only refers to the original IRA fund and that the accounts Inherited IRAs are taxable. different, which makes them completely separate from the original story. The Court’s argument is that an inherited IRA is a separate account that is created when the original account passes to a beneficiary after the death of the original owner.
While the Court’s rationale is that the tax-exempt status of IRAs changes because the beneficiary must receive distributions, the Court misses the fact that the original owner of the IRA would have been required to receive minimum distributions as of age 70 and a half if she were still alive. The Court clearly missed the boat with this ruling, but that does not change the fact that asset protection lawyers must now take this ruling into account when preparing and implementing an asset protection plan.
Courts are inconsistent regarding asset protection for legacy IRAs. Due to these inconsistencies, our firm recommends to our clients that the initial owner of the IRA create a living trust as part of a comprehensive estate plan. The beneficiary of the IRA must be the owner’s trust. An irrevocable descendants trust is then created and funded upon the death of the original owner. At that point, all IRA income is fully protected by the beneficiary’s trust, but fully accessible to the beneficiary.
This whole process can get very confusing, but with IRA assets becoming an increasingly important part of many clients’ assets, in situations where creditor protection of a client’s beneficiaries is a concern We all need to be aware of the potential asset protection issues presented by legacy IRAs.
Warning: You should always consult a professional when establishing and enacting an asset protection plan. Asset protection lawyers are trained specialists who can ensure that a plan that protects is put in place without the risk of it being deemed fraudulent.