Based on presentation by Robin Baum at the 2016 Cleveland Boy Scout Estate Planning Seminar. Article submission to the Ohio Probate Law Journal
For many people, the security of their retirement plan assets is not solely reliant upon the current financial market trends, but also the security of the assets should a legal suit be brought against them. The common concern for lower income individuals may involve bankruptcy and for those with higher incomes, may include claims that exceed malpractice coverage.
Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCA)
In the early 2000’s, questions arose surrounding IRAs and other retirement plan assets and how they were to be treated during bankruptcy. As a result, in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCA) was enacted. This Act affected both consumer and business bankruptcy law. Since then, traditional Individual Retirement Accounts (IRAs) have been protected under Federal law when a person declares bankruptcy.
The IRA exemption provision, originally leveled at $1 million, is now almost $1.3 million after scheduled increases resulting from inflation. This exemption does not apply to amounts that are rolled over from a qualified retirement plan such as a 401(k) and/or profit sharing plans, which are also protected under Federal law.
With respect to inherited IRA’s, Federal courts had been inconsistent as to whether or not they should be protected under the Act. In an attempt to rectify this problem, in 2014, the United States Supreme Court heard Clark v. Rameker, a case that questioned the protection of an inherited IRA. The Court determined inherited IRAs are not to be considered retirement funds under Federal law. The Court further reached this conclusion by stating that “one who holds an inherited IRA does not have the ability to invest new money in the account.”
It should be noted the beneficiary of an inherited IRA can also withdraw all of the underlying funds at their discretion and can spend the money at will without incurring a penalty. The Court also noted that because required minimum distributions ("RMD") have to be taken even though the beneficiary may be years from retirement age, they (the beneficiaries) have full discretionary access without penalty for premature distribution.
As a result of Clark v. Rameker, if one were to file for bankruptcy and also hold an inherited IRA, there would be no Federal protection for these assets. It should be noted, some states allow an individual to choose between federal and state bankruptcy exemptions in the filing. Ohio does not; an Ohio resident must use Ohio's exemptions if filing bankruptcy in this state. This is good news for Ohio residents that are concerned about their retirement assets in contemplation of filing for bankruptcy. Ohio Revised Code Section 2329.66 (A)(10) provides for a specific exemption for inherited IRAs. This provision may be considered to be in good timing as a large amount of IRA assets are passing from one generation to another in today's society.
Additional Asset Protection – Spendthrift Trusts
For individuals who are concerned about additional asset protection, setting up spendthrift trusts which are named as IRA beneficiaries may be a meaningful option. This trust vehicle will limit the beneficiary of the trust to gain control the funds of the trust, thereby providing asset protection from individual creditors in many states. When setting up these trusts, it is very important to guide clients to seek legal and tax counsel as this structure can have major legal and income tax implications if not constructed properly.
Another option and probably the most common type of trust is a conduit trust. A conduit trust would receive the minimum required distributions from the inherited IRA and then would distribute these funds directly to the trust beneficiary. Once the trust distribution is completed, asset protection is no longer afforded. However, the amount that remains in the inherited IRA remains protected from creditors.
Since this trust stretches the payout period from the IRA by distributing the funds over the (oldest) beneficiary’s lifetime, it also protects the beneficiaries from their own detrimental spending habits. In effect, the trust acts as a conduit, the annual distributions are taxed at the individual beneficiary’s level as opposed to the trust level. (The trust must satisfy IRS regulations in order to be considered a true conduit trust). An additional benefit of using a conduit trust can be tax savings. Within the tax code, the trust income tax brackets are highly compressed, so if a conduit trust is created properly, a family can achieve significant income tax savings over time assuming that the beneficiary may be a child in a lower tax bracket.
Generally speaking, there are four criteria that must be included in the conduit trust.
(1) It must be a valid trust under state law;
(2) it has to be irrevocable (or become irrevocable at the death of the original IRA holder);
(3) the underlying beneficiaries of the trust have to all be identified as being eligible designated beneficiaries; and,
(4) a copy of the appropriate trust documentation has to be given to the custodian of the IRA by October 31 of the year following the death of the original IRA holder
For self-employed taxpayers, a fairly new type of retirement plan for a one person business (or an individual and their spouse) is the Solo 401(k) plan. The Solo 401(k) plan is very flexible, allowing the business owner to potentially fund a significant annual amount (currently up to $59,000 per individual) into the plan. Because the plan contains both a 401(k) component (the "deferral") and a profit sharing component, it is included under the Employee Retirement Income Security Act of 1974 (ERISA). Note, these types of plans are at risk for asset protection purposes, other than bankruptcy. ERISA contains rules known as preemptive provisions, which take precedent over state laws relating to employee benefits. As a result, state laws covering ERISA plans do not apply to an individual's benefits. However, the Department of Labor does not consider two spouses who own a business to be employees for this purpose, thereby potentially subjecting a Solo 401(k) plan to the claims of creditors. If asset protection is important, the assets of the Solo 401(k) plan can then be rolled over into the new qualified plan sponsored by another employer.
IRAs and Rate of Return
In today's climate of low-return rates on interest and investments, many people may be inclined to try to increase their rate of return in their IRA. This may be especially tempting for a Roth IRA since a qualified distribution from a Roth is tax-free. One way to do so is to set up a self-directed IRA. A self-directed IRA refers to any IRA that allows one to direct the IRA's assets to be invested in non-traditional investment vehicles. Examples of these might include real estate, collectibles, and limited partnership interests, and may be done with either a traditional or Roth IRA. To participate in vehicle self-directed IRA, a trustee or custodian that specializes in this unique area must be identified and retained. One must also become well acquainted with the prohibited transaction rules.
Prohibited Transaction Rules
A prohibited transaction occurs when there is any improper use of an IRA by the owner, beneficiary, or other disqualified person. The latter would include an IRA fiduciary (one who exercises any discretionary authority in managing/administering the IRA) or family member. One who provides investment advice may also fall into this category. Examples of a prohibited transaction with an IRA include: borrowing money from the account for personal use; selling a property to the account under terms that do not constitute an arms-length transaction; buying property for personal use with IRA funds; receiving unreasonable compensation for managing an IRA; and others.
In a recent court case, an individual established a limited liability company to operate his business. He funded the new venture by rolling over his 401(k) account from his former employer into an IRA. The IRA then became the majority owner of the LLC. The individual, acting as the general manager of the business, was paid nearly $10,000 in compensation for his duties. The court found that this act constituted a prohibited transaction, since the taxpayer was a fiduciary of the IRA, and he created a situation where the IRA-owned business paid him compensation. He was dealing with the income or assets of the IRA for his own interest, which is known as "self-dealing". He was not being paid for his services provided to the IRA, which would not have been subject to the prohibited transaction rules. Therefore, the IRA was deemed to have been distributed to him and was fully taxed, along with the application of the 10% penalty.
In brief, prohibited transaction rules require that only the IRA benefits from its transactions; not the owner or their family.
Just about any type of real estate may be invested in via a self-directed IRA, including direct ownership, a limited partnership interest, etc. One may even invest their IRA in a business venture. However, as mentioned, extreme caution must be exercised to ensure that a prohibited transaction does not occur. If a prohibited transaction does occur, the account stops being treated as an IRA as of the first day of the year and is treated as distributing all of its assets to the owner at fair market value which qualifies as a taxable distribution for income tax purposes. In addition, the 10% premature distribution penalty may also apply, if the owner is younger than 59 1/2 years of age.
Not only would there be detrimental income tax ramifications, this may create an onerous asset protection dilemma. Creditor protection may be lost if a prohibited transaction occurs, even a minor one. It would then behoove the creditors of the IRA holder to look at all transactions of self-directed IRAs in order to come up with prohibited transactions, which would then potentially make the underlying assets available to them.
Therefore, if a client holds most of their assets in an IRA and can't afford to buy that piece of real estate that they desperately want but can't afford otherwise, they should set up a separate IRA for that piece of real estate, and make sure that they engage a qualified fiduciary who has considerable experience with managing self-directed IRAs.
Protecting retirement plan assets is a primary concern for most people. It is important to know the specifics of law and their financial implications related to different types of retirement plans and how the plan assets are treated. Generalizations regarding IRA’s can be dangerous. Understand the specifics of the account balances, including where funds may have originated from, in order to provide your clients with sound counsel and accurate advice.
This information is based on a presentation by Robin Baum at the 2016 Cleveland Boy Scout Estate Planning Seminar. Article submission to the Ohio Probate Law Journal.