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How to protect inheritance from creditors

How to protect inheritance from creditors

Disbursal of estates to heirs becomes public record. Creditors and collection agencies often review those records to look for people who owe them money among the recipients of inherited property. This alerts them to the possibility that a debtor now has the money to repay some or all of their debt.

If you file bankruptcy or have a creditor sue you for repayment, the only way you can shield those assets is by not owning them. Otherwise, inherited cash deposited in a bank could be seized to settle the debt. If your inheritance is real estate, the creditor may place a lien on the property. This means that the creditor can receive proceeds from a sale of the property to settle the debt or even force you to sell it.

Now, it may be in your best interest to use inherited funds to settle debts. It could save you from going to court and it could also help your credit rating and improve your chances of qualifying for credit or a loan later.

Methods of shielding inherited property

But if you want to preserve the inherited assets for another purpose, there are a few options.

One is to disclaim the property. This means you surrender all rights to the inheritance and typically transfer it to a descendant, such as your children. It’s advised that you disclaim the property before you take possession, otherwise a court may claim that you committed fraud. If so ruled, the court would reverse the transaction and award the inherited property to the creditor, or whatever amount is needed to satisfy the debt.

The person or people leaving you an inheritance can also shield those assets from creditors by placing them in a trust. A type of irrevocable trust used when there are concerns about an heir’s ability to preserve the estate is a lifetime asset protection trust. Under this arrangement, the assets belong to the trust and never the beneficiaries. This protects the assets from being spent down, claimed by creditors or other parties in a legal action, including current or future ex-spouses.

A similar type of trust used to protect estates when passed to heirs is a spendthrift trust. This is also an irrevocable trust in which the trust maintains ownership of assets. A spendthrift trust allows the person who created the trust, the trustor, to put restrictions on withdrawals. Also, a properly constructed spendthrift trust also shields the estate from possible creditor claims.

An inherited home can sometimes be protected from creditor action by living in it. A homestead exemption can be granted to a property that a person is using as his or her primary residence. If a property is granted this exemption, it cannot be sold to settle a debt if the amount of equity is less than the exemption amount of the state it’s located.

Inherited IRAs

Another type of property that has traditionally had creditor protection is individual retirement accounts (IRAs). IRAs funded with annual contributions have been protected up to $1.2 million. However, that protection does not apply to inherited IRAs.

In 2014, the U.S. Supreme Court ruled by unanimous decision that funds held in inherited IRAs are not retirement funds and therefore not exempt from a bankruptcy estate.

A person who inherits an IRA from his or her spouse is allowed to roll over those funds into another IRA, which maintains the creditor protection. But non-spouses who inherit IRAs cannot roll over funds. In addition, the non-spouse beneficiary must completely withdraw funds from the original account within a certain timeframe based on the age the original owner passed away.

Inherited IRAs by non-spouses can also be protected through the use of trusts. Specifically, there are two main trust options for IRAs: a see-through trust and a trusted IRA.

See-through trusts are most often used for large IRAs while trusted IRAs are typically used for smaller accounts. Under these arrangements, the trust owns the IRAs and its assets can be passed along as indicated by the IRA owner to the beneficiary(s). Establishing any kind of trust typically requires the service of a licensed attorney knowledgeable in estate planning.