Your IRA is a fund to be attacked by the people your children owe money to after you’re gone.
I know. Your children are amazing. And they may not owe money to anyone right now. But remember, nearly half of American households have expenses that equal or exceed their income, and most people simply don’t have the financial bandwidth to cope with accident or emergency medical expense. Your amazing kids should be fine. But even amazing kids make mistakes and face accidents.
11 USC § 522 helps shield your retirement plans from creditors if you are forced to declare bankruptcy. But it does not protect your children in the same situation.
The Supreme Court ruled in Clark v. Rameker that Heidi Clark’s inherited IRA were not “retirement funds” within the meaning of § 522. As a result, she lost (and her creditors gained) the $300,000 she had been left by her parents.
The solution to this problem is to set up a spendthrift trust to be the beneficiary of your IRA. Spendthrift trusts are trusts with a spendthrift clause designed to prevent creditors from taking assets in the trust. Because the IRA will be owned by the trust, creditors will find it much harder to reach your IRA, and your funds can help your children even after bankruptcy. So if your children face a substantial risk of default on their obligations, it may be worth protecting your children from creditors by using a spendthrift trust as an IRA beneficiary.
But make sure you set the trust up right, and that you designate your beneficiaries properly. There are significant tax consequences to this choice: if you use an ordinary spendthrift trust, the trust will almost certainly fail IRS regulations that allow preferential treatment for retirement benefits. This can easily cost your children millions of dollars of lost profits even if you don’t have millions of dollars in your retirement plans. Essentially, the problem is that a trust that is not correctly designed will fail to qualify for “see-through” status under IRS regulations, in which case the beneficiary will be forced to take all of the money out over five years–meaning not only does your heir lose the decades of tax benefits that could otherwise be extended over his or her lifetime, your heir also gets taxed on all that money over a five year period. The precise consequences of a failure of the trust to meet the IRS regulations will vary based on the terms of the trust.
While the ability to make a spendthrift trust the beneficiary of an IRA is an important estate planning tool in some cases, ultimately an attorney has to customize your estate plan to the facts and circumstances of your particular case.