How to Avoid the Loss of Inherited 401k and IRA Funds to Creditors in Your Bankruptcy Case

You may be surprised to learn that Congress gave America a financial break in 2005. You can stash away up to about $1,245,375 in 401k/IRA accounts and still file for bankruptcy without losing any of the funds.

What can you do to protect your inheritance for someone who will be your benefactor in the future, or if you are thinking of your own estate plans and distributions, the 401k and IRA funds that you intend to gift to those who you wish to inherit your estate someday?

Limitations in Bankruptcy Cases on 401k and IRA Funds Received Thru Inheritance

There is an important limitation to this Congressional gift. Effective June 2014, any 401k or IRA funds that you receive by way of inheritance—as opposed to earning the funds yourself—are no longer exempt in a bankruptcy proceeding. In fact, a bankruptcy trustee can take inherited IRA/401k funds from you if you file for bankruptcy after the benefactor who left the funds to you dies.

If you had earned all of the money in the 401k/IRA account yourself, then up to $1,245,375 in your IRA or 401k account could be exempted in a bankruptcy proceeding under Federal bankruptcy exemptions. However, if you receive 401k/IRA funds through an inheritance, these inherited funds do not enjoy the same protection.

Certain States Offer Protection, But Not Washington

Some states have special laws that have been in effect for many years that effectively override the June 2014 US Supreme Court ruling that denies protection for inherited IRA/401k funds in bankruptcy. Unfortunately, Washington is not one of those states. Unless you reside in Florida, Arizona, Alaska, or Texas, you have a big problem if you inherit 401k/IRA funds at the time you need to file for bankruptcy protection. That is, unless a special protective trust is in place before you inherit the 401k/IRA funds from your benefactor.

If a special protective trust is in place before the benefactor’s death, and the protective trust is the designated beneficiary, then it is possible to exclude the inherited 401k/IRA funds from your bankruptcy case.

Traditionally, the most common way of passing on 401k/IRA funds that are still in an account at the time of a benefactor’s death has been through making a “payable on death” beneficiary designation in a form provided by the investment custodian company managing and holding the benefactor’s 401k/IRA funds. However, should you need to file bankruptcy, use of this simple and traditional custodian standard form alone is no longer effective now as a shelter for those inherited 401k/IRA funds from a bankruptcy court trustee once you have received or stand to receive the funds as the beneficiary.

Therefore, if you are facing financial issues that might require bankruptcy protection, you absolutely do not want to receive inherited 401k/IRA funds through a “payable on death” beneficiary designation contained in the traditional custodian standard form. The reason for this advice is that inheriting 401k/IRA funds while you are in a bankruptcy case will remove any protection for those funds.

How to Protect Yourself and Your Heirs with a Protective Trust

Protecting your inherited 401k/IRA from bankruptcy court seizure is not particularly difficult. Protecting the inheritance from the bankruptcy court does require that your benefactor draft and put in effect the relatively simple legal trust documentation before your benefactor passes away. The protective trust documents must be in place before the death of your benefactor. Simply put, there is no “morning after” solution once the benefactor has died.

The takeaway here is that if a loving friend or relative intends to designate you as a beneficiary of a 401k/IRA account, then you should talk frankly with that benefactor about your financial troubles and economic prospects. You can work with your benefactor to avoid this threat to inherited 401k/IRA funds seizure by hiring an attorney like me to create a straightforward protective trust that names the trust as the beneficiary of any 401k/IRA funds that you will receive in the event of your benefactor’s death.

Protecting designated 401k/IRA funds that will pass on by way of inheritance is a two-step process. First, the 401k/IRA custodian supplies the traditional beneficiary designation form. Instead of naming you the beneficiary, however, your benefactor fills out the form to name the protective trust as beneficiary. Second, the language in the protective trust provides that upon the benefactor’s death, all IRA/401k the funds held in the trust must be used only for your benefit. This means that the funds are free from creditors—including the bankruptcy court trustee—if the trust documents are correctly executed.

As you have seen from the explanation above, these protective trusts, called spendthrift “Accumulation Trusts” or “Conduit Trusts” are relatively simple to set up. However, getting past the emotional challenge and broaching a very difficult subject with your benefactor is perhaps the most difficult step.

Discussing the Establishment of a Protective Trust with a Benefactor

Realistically, a frank financial discussion between a benefactor and a beneficiary is awkward at best and a cultural taboo at worst. Most folks are quite embarrassed to discuss a future gift or inheritance with a benefactor, getting started is often the hard part.

Few of us would start a conversation like this, “Dear Mom and Dad, I am having financial difficulties. If you have IRA/401k funds you intend to leave to me at the time of your death, you need to create a trust to protect those funds from loss in the event I end up filing for bankruptcy protection. You should call James MaGee to set up an appointment to draft a spendthrift Accumulation/Conduit trust.”

While it could be difficult to talk to your potential benefactor about estate planning, avoiding an initially awkward discussion with your benefactor could prove exceptionally costly and might result in events harmful to your benefactor’s wish that their estate directly benefit you and the benefactor’s other heirs.

Most benefactors are unlikely to know whether an Accumulation/Conduit Trust should be set up for you unless you tell your benefactor. Perhaps a way to take the initiative and avoid some of the awkwardness is to ask your benefactor to read this article to establish a foundation for your conversation about estate planning.

Let Us Help With Your Estate Planning

As you move on through life and accumulate 401k/IRA funds, presumably you do not intend that your life savings should be lost to a bankruptcy court trustee for distribution to creditors. Just as we have discussed above, if you leave 401k/IRA funds to a beneficiary at the time of your death without planning, your beneficiary could lose the funds you designate for that beneficiary if that person is experiencing financial problems that ultimately lead to a filing for bankruptcy protection.

Who can draft an Accumulation or Conduit trust to protect the 401k or IRA funds for an estate? Traditionally, estate planning attorneys who regularly draft wills and trusts establish these trusts. However, many bankruptcy attorneys like myself can affordably draft a spendthrift Accumulation/Conduit trust designed to keep your 401k/IRA funds from being ripped from the hands of your loved ones.

Call us for answers to your 401k and IRA questions and issues. If you need a spendthrift Accumulation or Conduit trust to shelter IRA or 401k funds, we are pleased to provide that service. If you are ready to revise your will and estate plan, then I can help with that task as well.