I recently got a call from a doctor who was being sued for malpractice and wondered whether her IRA was protected from creditors. The answer depends on whether she will need to seek bankruptcy protection, what state she resides in and who originally contributed to the plan.

Generally, the federal bankruptcy laws and Employee Retirement Income Security Act (ERISA) provides that qualified ERISA plans, such as employer’s pension and profit-sharing plans and 401(k)s), are 100% protected from a participant’s creditors. However, different rules apply when it comes to IRAs. If you funded the IRA by making annual contributions, then state law will determine the degree of protection. Most states provide for unlimited protection for such IRAs while federal bankruptcy law limits such protection, currently for amounts up to $1,362,800 and indexed to increase every three years. If, however, the IRA was funded solely through a rollover from a qualified plan, such federal bankruptcy protection is unlimited in amount. These exemptions also apply to SEP IRAs and SIMPLE IRAs.

Note that the exemptions do not apply against IRS claims. And if you are the nonspouse beneficiary of an inherited IRA, the foregoing exemptions may not be available. A nonspouse beneficiary of an IRA could continue the deferred benefit by transferring the IRA from the decedent’s account to an “inherited IRA” account. For a bankruptcy proceeding, the US Supreme Court ruled in 2014 that only the participant/owner of an IRA account is protected under federal bankruptcy law. The court reasoned that the exemption is available only for “retirement” savings, and since beneficiaries of inherited IRAs can withdraw amounts at any age without a penalty, they are not covered by the exemption. For such inherited IRAs, state law may provide the exemption, but most states have not enacted legislation and have not had court decisions specifically addressing this issue. A few states have extended protection to inherited IRAs, including Texas and Florida. On the other hand, a recent decision of a New York bankruptcy court determined that they are not protected.

If you are the spouse of an IRA owner, you can roll over the IRA into your own IRA. In such cases, it is not clear whether the IRA will be treated as a participant’s IRA and thus exempt under federal (and most state) laws or an inherited IRA. Since the spouse, if under 70 ½, would be subject to early withdrawal penalties, it is arguable that it is a “retirement plan” and should be exempt.

Given the uncertainty of the exemption available for inherited IRAs (as well as the uncertainty of which state a beneficiary may be living in when a creditor calls), what options are available to obtain protection for the beneficiaries who may inherit these accounts? The answer lies in the form of a trust. If the designated beneficiary is a trust for the benefit of the person who will inherit the account, then only the amounts distributed from the trust (which depends on how the trust is drafted) may be available to creditors. There are generally two trusts that can be used and that allow for the stretch out of minimum distributions for the beneficiary’s lifetime and thus continued tax deferral.

The first type is commonly referred to as a conduit trust. This trust must require annual distributions to the beneficiary of not less than the required minimum distribution (RMD) based on the participant’s age. Once that amount is distributed it would be available to the beneficiary’s creditors. The other type of trust commonly provides greater protection since it does not require any amount to be distributed to the beneficiary. Referred to as an accumulation trust, it simply requires the trustee to withdraw the RMD amount but allows it to be accumulated in the trust and thus protected from all creditors. This latter trust might not be as tax advantageous as the conduit trust and must be carefully drafted to come within the requirements set forth in the Tax Code in order to continue the deferred stretch-out benefit.

Based on the foregoing, one can see that it is not a simple matter to decide on the proper beneficiary designation. In addition to the creditor exposure concerns, there is a myriad of other planning considerations that an owner should consult their financial adviser about, including the financial circumstances of beneficiaries (considering their age, capacity, potential dependency on government benefits such as Medicaid, etc.) as well as possible tax-planning considerations for retirement accounts.

For more information, check out Gideon Rothschild’s website.