The executors are settling an estate — but the decedent owes money. What can the creditors take and what is reserved for the inheritors? There is no easy answer, and a variety of federal and state laws apply.
To start with, retirement accounts that qualify under the Employee Retirement Income Security Act are generally protected from creditors, bankruptcy and civil lawsuits. But they’re vulnerable to ex-spouses and the IRS — in the form of child support, federal income tax debts, criminal fines and penalties, or civil or criminal judgments. Some states shield IRAs in nearly all instances, while others offer only limited protection.
IRAs and 401(k) plans may be protected from creditors in bankruptcy proceedings. If you declare bankruptcy, your IRA assets are usually safeguarded and cannot be seized. Depending on state law, your IRA assets may be protected from other creditors, but rules vary.
Beneficiaries: another story
Beneficiaries of IRAs aren’t always afforded the same creditor protection as the original account owner. The U.S. Supreme Court has ruled that an inherited IRA for a non-spouse beneficiary is no longer protected from creditors’ claims when the beneficiary files for bankruptcy. Spouses can roll over inherited IRA assets into their own accounts, but non-spouse beneficiaries cannot commingle inherited IRA assets with their own retirement assets.
The Supreme Court’s decision highlights the importance of beneficiary designations for each of your retirement accounts. For situations where creditor protection is a primary concern and ERISA protection isn’t available, using trusts as beneficiaries is a popular option. If your children are listed as beneficiaries and have financial issues or face debt collectors, you can go the route of a trust, which may offer more protection. Talk to a professional about trusts that can protect loved ones.
Do other designations work?
What about a transfer on death designation? A TOD cannot be used for retirement accounts because retirement account beneficiaries must follow withdrawal and taxation rules. TOD transfers assets to a named beneficiary when the holder dies. Beneficiaries have no access or rights while you’re alive. You can use a TOD with a mutual fund, for example, that is not held in a retirement account. TOD accounts have a lot of benefits moving your assets without a will — which they supersede — or probate.
But TOD accounts don’t erase an estate’s debt; creditors can still go after assets in a TOD account. So it’s a good idea to review your beneficiary designations regularly as your priorities and goals change. If your listed beneficiaries are having financial difficulties, you may want to take steps to protect them and your legacy. If you’re worried about creditors pursuing your assets once you die, speak to an attorney as laws can be complex.
The bottom line
Of course, this is not the whole story. There are many complex rules and regulations, and only a professional can help you decide what is right for you. The point is that whether you are planning your will, planning to inherit or serving as an executor, you can’t assume anything — work with the pros!
