Asset protection

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.

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. Nor does it provide absolute protection to the assets of the low-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 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.

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.