The following is a guest post by CFP Board Ambassador, Joel T. Redmond, CFP®.

Don’t place too much confidence in a bulletproof vest if your enemy is using arsenic. 
– Anonymous 

One of the most important spheres of financial planning is asset protection. Asset protection (AP) can be complicated, but it basically boils down to making sure creditors have as little claim on your property as possible. 

On June 12 of this year, the United States Supreme Court reminded the American public that asset protection falls under the jurisdiction of our courts, when all is said and done. In the case of Clark et ux. v. Ramecker, trustee, et al., the Court decided that the assets inside an inherited Individual Retirement Account (IRA) are not protected from bankruptcy creditors. 

The salient facts of the case are as follows. In 2000, Ruth Heffron established a traditional IRA and funded it with $450,000. She made her daughter, Heidi Heffron-Clark, the sole beneficiary. Ms. Heffron died the following year, and Ms. Heffron-Clark inherited the account and began to take the required minimum distributions (RMDs) from it. Nine years later, in October 2010, Ms. Heffron-Clark and her husband filed a Chapter 7 bankruptcy petition. As they did so, they identified the $300,000 remaining in the inherited IRA as a bankruptcy-exempt asset.

The bankruptcy trustee and estate’s creditors, predictably, saw the matter quite differently. Their contention, which was upheld by the Supreme Court, was that the inherited IRA assets were not “retirement funds,” and therefore exempt, for three reasons. First, the holder of an inherited IRA is never allowed to make additional contributions to the account, so they essentially aren’t “accumulation” accounts, like traditional and Roth IRAs are. Second, no matter how many years away retirement is for the account holder, inherited IRAs require annual distributions. Third, the holder of an inherited IRA can withdraw the entire account balance at any time, without penalty. These three aspects of the accounts, the Court maintained, made inherited IRAs different from traditional IRAs and Roth IRAs, (and presumably other retirement plans as well).

In one respect, the Supreme Court’s decision seems quite straightforward. After all, the inherited IRA was never the fruit of Ms. Heffron-Clark’s own savings efforts or labor income. It was “found money.” But when seen from another vantage, the asset protection implications are stark. This decision points to a significant chunk of American wealth that is now, quite clearly, no longer as “bulletproof” from creditors as most thought.

How significant is this decision? It’s difficult to know for sure, but year-end figures from the Investment Company Institute (ICI) hold that there was $5.4 trillion inside IRAs (all types) as of year-end 2012. Indeed, IRA assets have grown by 10.23% since 1990.

Estimating non-spousal inherited IRAs at 1% of total IRA wealth, this could mean that $54 billion in IRA assets previously inaccessible to creditors are now no longer protected. It’s not a bad time to be a bankruptcy attorney! 

In light of this decision, many are asking themselves: if inherited IRAs aren’t protected, how long before traditional and Roth IRAs aren’t protected either? Good question. To answer it, we might look at two of the arguments used by the Court used to disqualify the inherited IRA from bankruptcy protection, and consider the applicability of these arguments to non-inherited IRAs.

The Court’s first argument was that no additional contributions can be made to an inherited IRA. But there are cases where the owner of a Roth IRA is not permitted to make additional contributions because his income is too high. Could the wealth of a Roth IRA holder expose his or her account to creditors?

The Court’s second argument was that inherited IRAs require annual distributions every year, whether or not the inheritor is of retirement age. Suppose then a 56-year-old has decided to take substantially equal periodic payments (SEPPs) from his or her traditional IRA under Section 72(t) of the IRC. In this case, the Court could easily argue that the early withdrawals under the SEPP provision made the traditional IRA no longer a retirement account, and not creditor-protected.  

Well, this is the bad news. What’s the good news? What can readers take away from these facts? There are many takeaways, but three stand out.

  1. Hire a Pro.  One of the most important things you can do to get a genuine idea of your asset protection exposure is to see a qualified professional. If you work with aCERTIFIED FINANCIAL PLANNER™ professional, ask him or her to take an initial peek at your balance sheet, and then ask for the name of a good asset protection attorney.
  2. Take the Moral High Ground.  Don’t just ask: will this work? Instead, ask: is it right? Time after time, in hundreds of asset protection actions and decisions, the courts have consistently ruled against those relying on “form over substance” defenses, attempting to shield themselves by operating under the letter of the law instead of its spirit. Instead, ensure that the asset protection move you’re contemplating is consistent with the intent of public policy. If you don’t know, see the first takeaway above.
  3. Document and Organize the AP Advice You’re Given, and Any AP Transactions you Undertake. The most conservative viewpoint in any AP situation is simple: you’re going to end up in court, and you’re going to have to explain what you did, and why you did it. If you can’t explain these things to a seven-year-old and convince them that it was the right thing to do, how can you convince a judge and jury of the same thing?

The Supreme Court’s decision has given occasion for significant controversy in the AP world. Instead of focusing on whether they’re right or wrong, however, good asset protection planning helps the wealthy predict what courts and creditors will do, not what they should do. The wealthy sometimes need a different antidote than Kevlar – and good planning can provide it for them.