Can an IRA Be Used to Pay Debts of Deceased?

In addition to being smart retirement savings tools, individual retirement accounts (IRAs) represent a wonderful opportunity to pass tax-advantaged assets on to the next generation. If the IRA's original owner named a beneficiary, that beneficiary inherits the account immediately. Creditors cannot claim the money. However, should the IRA pass to the estate of the decedent (person who has died), creditors may lay claim to it.

  1. Features

    • IRAs are generally a non-probate asset; that is, they can skip probate, the court responsible for rendering judgments on a deceased person's will. However, IRAs can only skip probate if the original owner named one or more beneficiaries; if the initial beneficiaries themselves died, the account could pass to any contingent beneficiaries the owner listed. In the absence of any beneficiaries, however, the account passes directly to the owner's estate. There, any creditors of the deceased person may try to claim the assets in court.

    Function

    • To name a beneficiary or beneficiaries, an IRA owner must fill out paperwork directly with the account's trustee. A trustee is the financial institution -- be it a bank, brokerage firm, insurance company or other type of financial management firm -- that administers the IRA. In doing so, the owner makes a contract with the trustee; the trustee agrees to turn the account over to the owner's designated beneficiaries. This contract voids other agreements the the owner has, including his will.

    Tax Implications

    • Designated IRA beneficiaries have a number of rights that estates do not get under Internal Revenue Service rules. IRA beneficiaries must start withdrawing money from the account shortly after the original owner dies; but under IRS rules, they have the option of withdrawing only a portion of their inheritance each year. This is a huge benefit, as assets inside an IRA are sheltered from income taxes. Should the account pass to the estate, IRS rules stipulate that it must be emptied within five years. Not only does this cut short the its tax benefits, but if the account is a traditional, SIMPLE or SEP IRA, whomever inherits the money will owe income taxes on the withdrawal.

    Legal Implications

    • If IRA assets wind up in probate court, any number of parties could lay claim to them, including the decedent's creditors and any survivors who decide to contest the will. If, for some reason, the decedent named people to inherit his retirement assets in his will, the judge would take that into account. However, the most those heirs could receive are the IRA's liquidated assets, minus taxes, creditor bills and lawyer fees.

    Prevention/Solution

    • IRA owners who are worried that their savings may end up in the hands of creditors should contact their trustees immediately and fill out the appropriate beneficiary forms if they have not already done so. Owners should also update their beneficiary forms in the event of life changes (e.g., a divorce and remarriage). IRA owners are welcome to name multiple beneficiaries, each of whom would inherit an equal portion of the account. They can also name contingency beneficiaries to inherit the account in the event that the primary beneficiary is not available.

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