Don't start counting your money the moment you inherit an IRA. Federal law protects 401(k) and other workplace accounts from creditors, but IRAs are a different kettle of fish. As an IRA beneficiary, your ability to fight off creditors -- yours or the deceased's -- depends on state law and district court decisions governing your part of the country.
The Owner's Creditors
The first obstacle is any creditors of the owner who demand payment from the estate. In North Carolina, for example, the owner's IRA assets are safe from creditors, but not once they become part of the estate. Usually, the executor pays creditors first out of the residuary -- assets the will hasn't specifically reserved for one of the heirs -- but if the owner dies without a will, the IRA might become vulnerable.
When the owner dies, the creditor who gets paid first is the IRS. If the owner's estate is large enough to trigger estate tax -- the trigger level varies year to year, but it's typically at least $1 million -- IRA assets are taxable along with everything else. If there's not enough money in the rest of the estate to pay the tax, the executor will have to extract it from the IRA, even if that cuts into your inheritance.
The rationale for protecting IRAs is to preserve the account owner's retirement fund. Unfortunately for you, bankruptcy courts around the country have ruled that because an inherited IRA doesn't represent your personal retirement fund, it's fair game for creditors. Some courts have ruled that creditors can take the IRA even outside bankruptcy. Other courts in other states have disagreed on both points. If you do have to pay a creditor, here's the kicker: as you're taking money out of the IRA, you pay tax on it as well.
If you're struggling under a mountain of bills or even thinking about bankruptcy, use state legal websites to research the law and the courts. It may be the law's on your side and not on the creditors'. If it favors the creditors, one option is to disclaim the inheritance and let it pass to the secondary beneficiary. Legally, disclaiming means you never get legal ownership of the money, so the creditors have nothing to seize on. The backup beneficiary gets the whole pot.
- New York Times: Protecting Retirement Accounts From Creditors
- Estate & Probate Law Blog: IRAs and Creditors ...
- Nolo: Can I Shield my IRA Funds From Estate Tax?
- Coleman Law Firm: Who Should Be the Beneficiary of my IRAs?
- National Law Review: Inherited IRAs Can Be Reached by Creditors to Pay Debts
- Oakland County Bar Association: Inherited IRAs in Courts
- Los Angeles Times: IRAs Could Be Fair Game in Lawsuits
- Fidelity.com: Inherited IRAs