As our struggling economy tries to sputter back to life, we still see its impact on our clients’ families. The stress of the real estate market crash and the wreckage of the lingering recession has left deep financial scars.
There is still a desire by better off (note, not well off) grandparents and parents to provide what they accumulated to adult children or grandchildren. They want to help them. But they’re hearing stories of children in bankruptcy, being pursued by banks for deficiency judgments, and chronically struggling.
One of the most common and logical ways to pass assets down to the next generation is via beneficiary designations on IRAs, 401Ks, life insurance, and annuities. On the face of it, the intent is good; but the strategy is flawed.
The Patient Creditor(s)
In most states creditors can obtain a judgment and then wait to pounce when assets pass to their target from a parent or grandparent. A recent court case highlights why beneficiary designations can actually be a trap for clients that actually benefits the creditors of their beneficiaries.
A recent case illustrates the problem: A husband and wife filed for bankruptcy. The wife’s mother died and left her an IRA worth $300,000, no doubt hoping this would give the couple an opportunity to start over. Mom’s intent was great, but her planning was terrible. The creditors of the married couple argued in bankruptcy court that an IRA is exempt from bankruptcy only if the daughter was the owner and not the beneficiary.
An appellate court ruled inherited IRAs are not protected from the beneficiary’s creditors. In this case, the entire IRA went to the creditors and not the daughter. (In re Clark, No. 12-1241, U.S Court of Appeals, 7th Circuit).
The Lesson for Advisors
If we could go back in time, what would we tell that family to prevent such an outcome? The only solution that makes legal sense would be to create an Inherited IRA Trust for the daughter. The Inherited IRA Trust becomes the beneficiary of Mom’s IRA. In this scenario it creates a legal wall between the beneficiary and her creditors. It is legal and would have radically changed the outcome of this case for the benefit of the daughter.
If designed and drafted properly, the Inherited IRA Trust would isolate the proceeds until the daughter is discharged from bankruptcy and then she could receive the benefits.
But doesn’t it cost a lot for a legal strategy like this?
We have all heard the whines of those who think it is “too expensive” to do — whatever it is that you are recommending. I can imagine hearing someone say: “But an IRA Trust would cost a lot of money!”
Let’s just say hypothetically that your client paid $30,000 to design an Inherited IRA Trust holding $300,000. Don’t panic, this is not the going rate.
If they paid 10% of their assets to protect 90%, isn’t that a good deal? In the legal case I referred to, the family paid $0 for zero legal protection and managed to keep nothing.
My point: If you have clients who have struggling beneficiaries, be a hero, educate them on this strategy.
As always, if you have a question or concern about a specific case, contact our office. We’re here to help.