If you follow my blog, you know that I’m not much on spouting case law. But every so often a case comes along in the estate planning arena that’s worthy of passing along.

In a unanimous decision on June 12, 2014, the Supreme Court of the United States, in Clark v. Rameker (June 12, 2014, No. 13 299) 2014 US Lexis 4166, affirmed a Seventh Circuit decision and ruled that inherited IRAs are not retirement funds within the meaning of the Bankruptcy Code. For those legal geeks out there, the specific part of the Code is 11 USC §§ 522(b)(3)(C) and (d)(12).

This decision resolves a split among the Circuit courts about the status of IRAs that parents leave to their children. The courts have long held that typical IRAs are protected from creditors as they are set up specifically for retirement to the point that you’re penalized if you take out funds early. In contrast, money in an account inherited from a parent can be withdrawn at any time. Justice Sotomayor, writing for the court, said that this crucial change in the status of the account makes it less like retirement savings and more like a pot of money available to pay off creditors. Otherwise, Sotomayor said, nothing would prevent someone who declares bankruptcy from using the entire balance of an inherited IRA “on a vacation home or a sports car immediately after her bankruptcy proceedings are complete.”

To add insult to injury, if the money comes out of the inherited IRA and is used to satisfy creditors, it also becomes taxable income. So Uncle Sam gets his share first, then the creditors get the rest. Your children have now lost the ability to stretch the IRA payments out over the course of their lifetime and minimize the income tax ramifications.

Now, for most of us that have children without creditor issues, this isn’t a problem. But some children have had difficulties, and you never know what the future might bring for others. So, is there still a way to protect these assets and minimize the tax consequences? I’m glad you asked.

One way of accomplishing this is to change the beneficiary of your IRA from your children to a trust. Upon your death, a properly crafted trust would create an irrevocable discretionary trust for your children. The trustee can then stretch the IRA payout into this discretionary trust and control when those assets are then given to the child. So long as the child is not a trustee, he would have no control over when he gets any of the assets from the now inherited IRA nor how much of these assets. Since it’s now out of the child’s reach, it’s out of the creditor’s reach as well.

Keep in mind that this discretion by the trustee is to determine whether the child has creditor difficulties or not. This may cause contention between the trustee and the child beneficiary if the child wants more than the required minimum distribution from the inherited IRA and the trustee refuses. If the trustee and beneficiary are siblings, this contention may exacerbate any existing tension between them. The point is that this type of trust is not to be used lightly and only after discussions with the various family members and with a trusted estate planning attorney.