Take-Away: Some states, but sadly not Michigan, protect an inherited IRA from the inheritor’s judgement creditors.

Background: Because substantial wealth in our society is held in IRAs, the protection of those assets from creditor claims is critically important in estate planning. Both federal and state laws generally provide considerable protection to IRAs from judgment creditors or if the IRA owner files for bankruptcy.

Federal Bankruptcy Exemption: The Bankruptcy Code [Sections 522(b)(3)(C) and (d)(12)] exempt IRAs, both traditional and Roth, from the bankrupt’s estate, but that exemption is subject to a dollar limit. Currently that dollar limit is $1,362,800 (aggregated for all of the bankrupt’s IRAs, not each IRA) which amount is adjusted every 3 years to reflect inflation. The next adjustment due to this dollar limit is 2022.

SEP and SIMPLE IRAs: Both SEP IRAs and SIMPLE IRAs, since they are technically qualified plans, are also exempt in bankruptcy, but they not subject to the dollar cap faced by traditional and Roth IRAs. Note, however, that if a SEP IRA or SIMPLE IRA is subsequently rolled into a traditional IRA by the owner [IRC 408(d)(3)] the funds will again be subject to the Bankruptcy Code’s dollar cap, unlike other qualified plan account balances that can be rolled into a traditional IRA and still be of an unlimited amount that is exempt in the owner’s bankruptcy. [11 USC 522(n).]

Michigan IRA Exemption: Michigan’s exempt property statute also protects retirement accounts from judgment creditor claims. Qualified plan accounts, e.g. 401(k) accounts are fully protected. [MCL 600.6023(k).] IRAs are also protected under the same exempt property statute, but with some limitations:

MCL 600.6023(j): “An individual retirement account or individual retirement annuity as defined in 408 [traditional] or 408a [Roth.] This exemption applies to the operation of the federal bankruptcy code as permitted by section 522(b)(2) [11 USC 522.] The exemption does not apply to any amount contributed to the IRA if the contribution occurs within 120 days before the debtor files for bankruptcy. Nor does the exemption apply to an IRA to the extent: (i) the IRA is subject to a court order pursuant to a judgment of divorce or separate maintenance; (ii) the IRA is subject to a court order concerning child support; or (iii) contributions, plus earnings, exceed in the tax year made or paid, the deductible amount allowed under section 408. This limitation does not apply to rollovers.”

Inherited IRAs: Federal law and state law differ on whether inherited IRAs are exempt from creditor claims.

Federal: Federal law, as announced by the U.S. Supreme Court, is clear that an inherited IRA is not exempt in the inheritor’s bankruptcy. In Clark et ux v. Rameker, Trustee 573 U.S. 122 (2014) the Court held that unlike a contributory IRA, an inherited IRA is not exempt under the Bankruptcy Code,  because the funds held in an inherited IRA are “not retirement funds” within the meaning of the bankruptcy statute. This conclusion was reached when the Court compared an inherited IRA to a traditional contributory IRA, noting the following distinctions:

(1) the owner of an inherited IRA may withdraw the funds at any time without paying a penalty;

(2) the owner of an inherited IRA may not make contributions to the inherited IRA;

(3) the owner of an inherited IRA can access the funds at any time (without penalty) for current consumption; and

(4) the owner of an inherited IRA must either withdraw the funds within 5 years [now 10 years after the SECURE Act] or over the inheritor’s life expectancy on an annual basis.

Thus, the law is clear at the federal level that an inherited IRA will not be protected if the inheritor later files for bankruptcy.

States: Outside of bankruptcy, it is unclear whether an inherited IRA should be distinguished from a contributory IRA and Roth IRA for exemption purposes, because state laws vary on the inherited IRA’s exemption. Currently a majority of the states, including Michigan, provide by silence that an inherited IRA will not be protected from creditor claims. Thus, there is no reference to inherited IRAs in Michigan’s statute noted above.

However, a handful of states have amended their exempt property statutes to expressly provide that inherited IRAs, like traditional contributory IRAs and Roth IRAs, are exempt from creditor claims.

States that Exempt Inherited IRAs: Those states that exempt inherited IRAs from creditor claims include: Alaska, Arizona, Florida, Idaho, Missouri, North Carolina, Ohio, and Texas. Florida’s statute reads:

“Any money or other assets or any interest in any fund or account that is exempt from claims of creditors of the owner, beneficiary, or participant under paragraph (s) [referencing sections 401(a), 403(a), 403(b), 408, 408A, 409, 414, 457(b) and 501(a) of the Tax Code] does not cease to be exempt after the owner’s death by reason of a direct transfer or eligible rollover that is excluded from gross income under the Internal Revenue Code, including, but not limited to a direct transfer or rollover to an inherited individual retirement account.

Example: Accordingly, the distribution of an inherited IRA to two or more designated beneficiaries could lead to different results. If one beneficiary resided in Michigan at the time their portion of the IRA was inherited, and that beneficiary had a judgment entered against them, the judgment creditor could attach their inherited IRA to satisfy the unpaid judgment. The other designated beneficiary who happened to live across the state line in Ohio at the time their portion of the IRA was inherited, who also had a judgment entered against them, could retain the inherited IRA (at least for 10 years under the SECURE Act) to a date when the Ohio judgment was not longer collectible.

Conclusion: Michigan’s exempt property statute is woefully out-of-date. It would be nice if that statute was modernize and brought into the 21st century to include provisions that would protect inherited IRAs from creditor claims.