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Are inherited IRAs protected during bankruptcy?

Despite the fact that the stock market has been anything but predictable over the last few years, millions of Americans still dutifully divert a portion of their income into either an employer-sponsored 401(k) or an Individual Retirement Account in the hopes of building a comfortable nest egg for their golden years.

It should be noted, however, that many younger people aren't just relying on their own retirement savings for their future financial security, but also on some of the funds they stand to inherit from their parents or grandparents, many of whom have reaped the benefits of prosperous financial times.

Indeed, researchers estimate that 93.6 million estates here in the U.S. will transfer upwards of $59 trillion from 2007 to 2061, marking the largest wealth transfer in the nation's history.    

One question to naturally arise then is the degree to which these inherited assets would be protected in the event that a financially troubled heir eventually seeks the fresh start offered by Chapter 7 bankruptcy. For example, would an inherited IRA be protected from creditors in bankruptcy?

In general, what does the law have to say about retirement accounts and bankruptcy?

The federal Bankruptcy Abuse Prevention and Consumer Protection Act dictates that 401(k)s that qualify under the Employee Retirement Income Security Act -- ERISA -- are protected from creditors during bankruptcy. Non-ERISA plans such as IRAs are also protected with roughly $1.2 million considered exempt under federal law.

What about inherited IRAs?

While there was longstanding confusion among the federal courts as to whether inherited IRAs should be extended the same bankruptcy protection as individually owned IRAs, the Supreme Court of the United States definitively resolved the matter back in April 2014 with its decision in Clark v. Rameker.

What decision was reached in Clark v. Rameker?    

The high court ruled that inherited IRAs are not extended the same protection under U.S. bankruptcy law as individually owned IRAs. Here, the court based its decision on the fact that those who inherit an IRA are prevented from investing any new funds, must accept mandatory distributions from the account no matter their age, and can use the funds for any reason they desire without incurring any penalty.

Does this mean that inherited IRAs are never protected in bankruptcy?

Not necessarily. U.S. bankruptcy law enables the 50 states to create their own exemptions. As it turns out, seven states -- including Florida -- have actually decided to make inherited IRAs completely exempt.

What all of the following serves to underscore is that the bankruptcy process, while inherently complex, is also likely more filer-friendly that you might otherwise imagine. To learn more, please consider speaking with an experienced legal professional. 

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