I’ve consulted many clients over the years who used their IRA funds to buy an annuity investment. The most common questions I get are as follows.
- What is an annuity? Now mind you, these are persons who already own an annuity.
- Can I cancel it and get my money back to invest in something else, and is there a penalty?
Most of our clients who own an annuity with an IRA are seeking to use those retirement plan dollars in a new investment opportunity with the goal of increasing returns. However, “getting rid” of an annuity owned by your IRA isn’t as easy as selling a mutual fund or stock investment.
WHAT IS AN ANNUITY?
An annuity is a contract with an insurance company whereby the person invests a lump-sum (or a series of payments) with an insurance company and the insurance company agrees to pay certain sums to the owner over their life. There are many variations of annuities but the simple explanation is that you give up money now to an insurance company and they promise to pay you money later. The longer you wait to get paid the more they will pay you later on.
CAN I CANCEL MY ANNUITY?
You can cancel an annuity but you may be subject to a surrender penalty. Most annuities have a surrender penalty whereby the owner of the annuity is penalized for requesting a return of the investment within a certain period of years of the initial investment. This time period is known as the surrender period and on average will last from 5 to 10 years. The surrender penalty on a 10 year surrender time period is usually 10% and decreases by 1% each year thereafter until it goes to zero after 10 years.
So, if you invested a lump-sum of $100,000 into an annuity and one-year later (in years 2) you wanted to get the entire $100,000 back out, you would be subject to a 9% surrender penalty of $9,000. That would mean you could get back $91,000 but would forfeit the remainder. Some penalty schedules are more punitive and they all vary. The surrender schedule is in the annuity contract documents and can also be requested at any time from the company holding the annuity.
KEEP IT IN AN IRA TO AVOID TAXES
Once you cancel an annuity owned by your IRA, the funds need to stay within an IRA (e.g. self-directed IRA) in order to avoid taxes and penalties from the IRS. You can request the annuity company to transfer the IRA annuity cash balance over to a new IRA custodian of your choosing. Once you’ve taken these steps, you’re retirement plan funds will be in an IRA and available to invest in stock, bonds, mutual funds, real estate, private companies, precious metals, and all other investments available to IRAs.
The United States Supreme Court recently issued a 9-0 opinion holding that inherited IRAs are not exempt and protected from creditors in bankruptcy. As a general rule, IRAs receive special protections from creditors and cannot be reached by the creditors of the account owner. In Clark v. Rameker Trustee, Clark inherited her mother’s large IRA upon her mother’s death. Nine years later, Clark filed bankruptcy and sought to protect the inherited IRA from the reach of her own creditors. Under the bankruptcy code, “retirement funds” are protected from the reach of creditors and may generally be kept by the owner following bankruptcy. Justice Sotomayor, who wrote the opinion of the Court, wrote that inherited IRAs (not to include spousal inherited accounts) do not constitute “retirement funds” for three reasons. First, the owner cannot continue to contribute to the account. Inherited IRAs remain in the deceased owner’s name and cannot receive additional contributions from an heir. Second, the new owner is forced to take required minimum distributions from the account under a different set of rules than typical retirement accounts. And third, the account owner may withdraw the balance at any time without a 10% early withdrawal penalty. Because of these reasons the Court held that inherited IRAs are not “retirement funds” within the meaning of IRC 408 and as a result they are not protected from creditors. Consequently, the Clark’s entire inherited IRA is subject to the claims of creditors in bankruptcy.
In addition to the Court’s ruling in Clark, it is important to note three other facts regarding inherited retirement accounts and creditors.
- IRAs Inherited From a Spouse. When a surviving spouse inherits a retirement plan from a deceased spouse, the surviving spouse may simply roll over the deceased spouses account into an IRA owned by the surviving spouse and the retirement funds become a new account or add to an existing account of the surviving spouse. This is different from a non-spousal inherited account that was involved in the Clark case. Spousal inherited IRA funds go into the surviving spouses own IRA and are subject to the typical retirement plan rules. Because of this, inherited spousal retirement plans funds are different than that of non-spousal inherited funds and are not subject to the Court’s holding in Clark.
- Certain States Specifically Protect Inherited IRAs. When in bankruptcy a creditor can seek the protection of certain assets from creditors under federal exemptions and/or they can seek the protection of certain assets (such as IRAs) under the laws of their State. Under the laws of a few states, inherited IRAs are specifically protected from creditors and as a result the Court’s opinion in Clark would likely not apply. Those states include, Arizona, Texas, and Florida.
- Consider an IRA Trust For Large IRAs. If you have an estate comprised of significant IRA holdings, you may be able to establish a special IRA Trust, which can be used to shelter your IRA funds from your heir’s creditors. A trust should only be listed as a beneficiary of an IRA upon careful planning and consideration as the Trust needs to contain certain provisions in order to qualify as a valid trust under retirement plan rules.
Since inherited IRAs have special rules and procedures, it is recommended that person’s with large IRAs seek the guidance and assistance of an attorney in planning their estate and retirement fund’s future. Also, if you have an inherited IRA and are considering bankruptcy, stop, consult, and plan with the proper counsel lest you lose the account to creditors.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook
Asset Protection for Self Directed IRAs: Is My IRA Protected?
By: Mathew Sorensen, Partner KKOS Lawyers
When analyzing asset protection for self directed IRAs we must consider two types of potential threats. First, we must analyze how a creditor can collect against an IRA when the creditor has a judgment or claim against the IRA owner personally. Secondly, and most importantly for self directed IRA owners, we must analyze how a creditor can collect against an IRA or its owner when the IRAs investment incurs a claim or judgment.
There has been much written on the protections to retirement plans that prevents a creditor of the IRA owner from collecting against the IRA to satisfy their judgment. Various federal and state laws provide this protection which prohibits a creditor of an IRA owner from collecting or seizing the assets of an IRA or other retirement plan. For example, if an individual personally defaults on a loan in his or her personal name and then gets a judgment against them the creditor may collect against the individual’s personal bank accounts, non retirement plan investment accounts, wages, and other non-exempt assets but is prohibited from collecting against the IRA or other retirement plans of the individual. Even in the case of bankruptcy a retirement plan is considered an exempt asset from the reaches of the creditors being wiped out. U.S. Bankruptcy Code, 11 U.S.C. §522. Because of these asset protection benefits retirement plans are excellent places to hold assets outside the reach or creditors.
The second asset protection issue and the focus of this article is to consider how an is IRA protected from claims arising from the IRA’s investments and activities? This issue is one that is particularly important to self directed IRA accounts since some self directed IRA investments are made into assets that can create liability to the IRA and the protections preventing a creditor of the IRA owner against the IRA assets does not apply to liabilities arising from the IRAs investments. In other words, if the IRA has a liability the IRA is subject to the claims of creditors. For example, if a self directed IRA owns a rental property and the tenant in that property slips and falls the tenant can sue the self directed IRA who owned and leased the property to the tenant. Consequently, the IRAs assets are subject to the collection of the creditor including the property the IRA owned and leased to the tenant as well as the other assets of the IRA. But what about the IRA owner and their personal assets, are their personal assets also at risk?
Let’s analyze this issue further and look at whether a creditor/plaintiff against the IRA can also sue the IRA owner personally if the IRA’s assets are not sufficient to satisfy the judgment against the IRA. IRC § 408 states that an IRA is a trust created when an individual establishes an IRA by signing IRS form 5305 (this form is completed, with some variations, with every IRA) with a bank or qualified custodian. Courts have analyzed what an IRA is under law and have stated that they are a trust or special deposit of the individual for the benefit of the IRA owner. First Nat’l Bank v. Estate of Thomas Philip, 436 N.E. 2d 15 (1992). In other words, the IRA is not a separate entity or trust which would be exempt from creditor protection of its underlying owner. Since the IRA is a trust that is revocable and terminated at the discretion of the IRA owner, each investment in fact is truly controlled by the IRA owner as her or she could terminate the IRA at any time and take ownership in their personal name. As a result, the IRA is akin to a revocable living trust used for estate planning which trust is commonly understood by lawyers and courts to provide no asset protection and prevention of creditors from pursuing the trust creator and owner from liabilities and judgments that arise in the trust. Following this same rationale, a self directed IRA would likely be subjected to a similar downfall in the event of a large liability which is not satisfied by the assets of the IRA. As a consequence, the personal assets of the IRA owner may be at risk.
As a result of the asset protection liabilities for self directed IRAs, we recommend that self directed IRA owners consider an IRA/LLC for the asset protection reasons that many individuals use LLC’s in their personal investment and business activities. Simply put, an LLC prevents the creditor of the LLC from being able pursue the owner of the LLC (in this case the IRA). An IRA/LLC is an LLC owned typically 100% by the IRA and the LLC would operate and take ownership of the investments and the liabilities similar to an LLC used by an individual. For example, instead of the IRA taking ownership of a rental property directly and leasing it to a tenant the IRA/LLC would instead take title to the property and would lease the property to the tenant. When the IRA/LLC owns and leases the property any claims or liabilities that arise are contained in the LLC and as a result of the LLC laws a creditor is prevented from going after the LLC owner (in this case the IRA, or the IRA owner).
There are certain types of self directed IRA investments that benefit greatly from the asset protection offered by an IRA/LLC. Rental real estate owned by an IRA achieves significant asset protection benefits from an IRA/LLC since rental real estate can create liabilities to their owner. Other self directed IRA investments such as promissory note loans, precious metals, or land investments do not have the same asset protection issues and potential to create liability for the IRA and as a result an IRA/LLC isn’t as beneficial from an asset protection perspective for these types of investments.
For more information on the benefits of an IRA/LLC please contact Mathew Sorensen, Partner at KKOS Lawyers at 602-761-9798.