Asset protection

Disclaimer: ''This is not legal advice. Consult a lawyer before implementing any asset protection strategy. This article discusses general principles and suggests ideas that could be helpful in orienting yourself in preparation for such a consultation. This article may contain errors. Relevant law may vary from state to state.''

The purpose of this page is to describe and assess various asset protection strategies designed to mitigate the risk of financial ruin resulting from a lawsuit by an outside party. "'Asset protection (sometimes also referred to as debtor-creditor law) is a set of legal techniques and a body of statutory and common law dealing with protecting assets of individuals and business entities from civil money judgments. The goal of all asset protection planning is to insulate assets from claims of creditors without concealment or tax evasion.'"

Internal family matters, including divorce proceedings, are not addressed here.

Insurance
Insurance can be required by law, or be electively purchased, to provide protection from certain potential liabilities. In addition, the cash values that build up in whole life, universal, and variable universal life insurance policies can be subject to creditor claims.

Insurance for asset protection
The following types of insurance allow individuals to purchase protection from liability claims.


 * Auto insurance often covers both risks of property damage and needed medical care as a result of an incident involving a car. In most places, some degree of coverage is required by law in order to drive a car.  Deductibles are usually available, and amounts and types of coverage are often highly customizable beyond the legally required minimum.


 * Homeowner's insurance, renter's insurance, and landlord's insurance generally provide coverage for loss of one's own property and liability to others occurred because of their presence on your property. Deductibles are usually available.  While a homeowner is paying off a mortgage on their house the lender will usually require homeowner's insurance, as may a buyer during the process of selling the house.  There are always excluded perils, which means that if the loss is caused by one of those items then the insurance provides no coverage.  There may be ways to cover these exclusions, either by riders amending the standard policy for an additional fee or by purchasing specialty insurance such as earthquake or flood insurance.


 * Professional insurance may take many names, depending on the profession, such as malpractice insurance or errors and omissions insurance. This insurance can protect the professional from paying directly for losses caused to their clients, and potentially others, by their work.


 * Umbrella insurance provides additional liability insurance above and beyond that contained in your other insurance policies.  Umbrella insurance will generally need to be coordinated with the liability limits under those other policies.

Life insurance cash values
Federal bankruptcy law provides an exemption of $11,525 for the cash value of a life insurance policy in bankruptcy proceedings. Additional liability protection against creditor claims to life insurance cash values is dependent on state law. In many cases it is also dependent on who is insured by the policy, who owns the policy cash values, and who is the beneficiary of the policy proceeds after the death of the insured. Some states protect all or a portion of the owner's cash value against creditors of the owner. Other states do not protect life insurance at all, or only protect proceeds that are paid to policy beneficiaries after the death of the insured.

Splitting up assets between spouses
If one spouse has high risk of liability and the other spouse has a low risk of liability, it is often in both spouses' interest to title some assets in the low-liability-risk spouse's name. To reduce the risk of this being deemed a "fraudulent conveyance," the splitting up of assets should occur long before the high-liability-risk spouse is sued.

According to Klueger & Stein LLP, "In common law states ... [c]reditors of the debtor spouse cannot reach the separate property of the non-debtor spouse, with the limited exception for necessities of life."

Example: Dr. Smith is a obstetrician. She worries about being sued. She is married to Mr. Smith. He is a stay-at-home dad who believes he is at low risk of being sued. Half of their assets are owned by Dr. Smith. The other half are owned by Mr. Smith. If Dr. Smith is sued in a common law state, the funds in Mr. Smith's name generally cannot be seized by creditors because they are owned by Mr. Smith, not Dr. Smith. By contrast, if the funds had been held in a joint account, all of the assets would have been exposed to creditors.

Admittedly, this strategy does not provide any protection to assets that remain in the name of the high-liability-risk spouse. Also, tax consequences should be considered. Finally, the implications of this strategy vis-a-vis the possibility of divorce should be taken into account.

Investing in a primary residence
Many states offer a "homestead exemption," meaning that a resident's principal residence is partially or fully exempt from creditors. Laws vary significantly from state to state. Arkansas, Florida, Iowa, Kansas, Oklahoma, South Dakota, and Texas offer nearly unlimited homestead exemptions, subject to physical limits on the homeowner's acreage. In these states, a homeowner can shield millions of dollars from creditors via ownership of his or her primary residence.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 limits a person's ability to move from one state to another to take advantage of a superior homestead exemption. This limitation applies only to those who have declared bankruptcy. Specifically, the Act imposes a "'limitation of the state homestead exemption in bankruptcy to $125,000, regardless of state law providing for a larger or unlimited exemption. This limitation applies to homestead interests that are acquired within a 1215-day (40 months) period prior to the filing of the bankruptcy petition.'" If one has violated the law, the limitation is $125,000 regardless of holding period.

Investing in a 401K
The Employee Retirement Income Security Act (ERISA) provides 401Ks and other ERISA-governed retirement plans with rock-solid protection from creditor judgments. This protection applies to judgments other than bankruptcy, and it applies in all 50 U.S. states.

Individual Retirement Accounts (IRAs) don't receive those federal protections, although some states shield IRA assets from creditor judgments.

The language of the federal law governing rollover of assets from a 401K plan to an IRA is ambiguous. That law, the Bankruptcy Abuse Prevention and Consumer Protection Act, states that $1 million in IRA assets is protected in bankruptcy without regard to amounts attributable to rollover contributions.

According to the Wall Street Journal, "most experts say that phrase should be interpreted to mean that amounts rolled over from employer plans get creditor protection, as well. But others ... believe it means that the $1 million is determined 'without regard' to whether the amounts are attributable to rollovers."

In short, maximizing contributions to a 401K plan is an excellent asset protection strategy; investors considering rolling over assets from a 401K  plan to an IRA should carefully consider the asset protection implications.

Investing in an IRA
For anything other than a bankruptcy, protection of IRAs and Roth IRAs from creditors is determined by state law. Most states provide full protection. Some states, including California, protect only what is “reasonably necessary” to support the owner and his or her dependents.

At the federal level, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provides traditional IRAs and Roth IRAs with an inflation-adjusted $1 million dollar cap exemption in federal bankruptcy proceedings. The act provides SEP and SIMPLE IRAs with a 100% exemption with no cap limit. Rollovers from employer plans have a 100% exemption with no cap limit. However, retirement plan assets can be tapped for family support and the division of property at divorce. These assessments are executed through a qualified domestic relations order (QDRO). IRA assets can also be tapped through IRS federal tax liens.

Investing in a 529 plan
At the federal level, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 shields from creditor's 529 plan assets owned by a bankrupt beneficiary, provided the deposits meet certain criteria (for example, the deposits must have been made at least two years prior to bankruptcy).

Many state laws provide protections as well, and unlike the federal legislation, the state-level protections apply to claims brought outside the bankruptcy process. For example, the following states provide creditor protection to both owners and beneficiaries of 529 plan assets: Alaska, Arkansas, Colorado, Florida, Kansas, Kentucky, Maine, North Dakota, Pennsylvania, South Dakota, Virginia, and West Virginia.

Investing in a variable annuity
State law determines the extent to which an annuity's cash value or income payments are subject to creditor claims. Many states offer no protection. Some states offer limited protection to cash values and/or the income streams from annuitizing the contract. A number of states do offer 100% exemption of annuity cash values from creditor claims. These states include Arizona, Florida, Hawaii. Maryland, Michigan, New Mexico, Oklahoma, and Texas. Two other states offer 100% exemption of cash values after a minimum holding period: Kansas (if held more than one year) and Louisiana (if held for more than nine months). Variable annuity subaccounts are isolated from an insurer's general account, and are thus protected against a sponsoring insurer's creditors in the case of an insurance firm default.

Living life carefully
Perhaps the most effective asset protection strategy is to try to steer clear of activities that create liability. This means driving carefully, avoiding barroom brawls, and not owning a dangerous dog. It also means being discreet about one's assets so as to avoid interest from would-be litigants.

Forum discussions

 * 401K vs IRA in terms of asset protection