Lawsuits, accidents, and other unexpected events can put personal assets at risk of loss. Many people seek ways to protect their assets from lawsuits and creditors. While there are expensive asset protection packages offered by various finance professionals, there are much simpler ways to protect most assets that should be implemented before considering the more elaborate plans.
When evaluating asset protection, the differences between federal and state laws are important.
Federal law for the most part covers only federal bankruptcy court actions. In other claims on assets, state law will determine whether or not an asset is protected. The exception is employer pension plans. The Employee Retirement Income Security Act of 1974 provides that most pension plan assets are protected from creditors of the participant regardless of state law.
Each state sets its own laws on asset protection. While there are some general principles and strategies, before implementing a strategy a check of state law is required. For personal assets, the state of the owner’s residence usually determines the protection, while the location of real estate often determines which law applies.
Retirement plans: As mentioned above, ERISA protects employer-sponsored retirement plans from being reached by creditors. This protection covers traditional defined benefit plans as well as 401(k) plans.
IRAs receive limited protection under ERISA, but have wide protection under federal bankruptcy law. An IRA that consists of a rollover from a 401(k) account has unlimited creditor protection. Otherwise, up to $1 million in an IRA is exempt from creditors.
Unfortunately, the IRA protection applies only in federal bankruptcy actions. In any other action involving a creditor and an IRA, state law controls. Some states exempt IRAs completely from the reach of creditors. Others protect IRAs up to a ceiling amount. There also are a few, such as South Carolina, that allow the courts to protect IRAs ?to the extent that justice requires.?
More details about federal bankruptcy law protection of assets are in the May 2006 issue and in the Estate Watch section of the Archive on the members-only section of the web site.
Strategy: Maximize the use of 401(k) plans and other employer-sponsored retirement plans. Check state law before contributing to IRAs.
joint ownership. In many states owning property jointly protects all or half the asset from creditors. In states that recognize ownership as tenants in the entirety, the asset is protected from creditors of either spouse. Only real estate can be owned as tenants in the entirety and only by married couples.
Don’t overdo joint ownership. As discussed in past visits, joint ownership has Estate Planning disadvantages, especially tax disadvantages. Joint ownership also can invalidate parts of a prenuptial agreement.
Strategy: Consider joint ownership for select assets, but only in consultation with an estate planner.
Insurance products. In many states, annuities and the cash value of life insurance policies are exempt from creditor claims. Someone concerned about lawsuits or creditors seizing assets can do a portion of his or her investing through these products instead of taxable accounts. Their disadvantages include higher costs, limited investment options, and the possible conversion of capital gains into ordinary income.
Strategy: Move some investments from unprotected taxable accounts to appropriate insurance contracts.
Homesteads. A primary residence receives some degree of exemption from creditors in almost all states. A few states, such as Texas and Florida, provide generous exemptions, while others put a ceiling on the value of protection for homes.
Strategy: Learn your state’s homestead exemption. If it is low, consider moving to a state with a higher exemption. If it is high, consider the feasibility of purchasing a more valuable home to exempt more wealth.
Mortgages. A home or other property can be encumbered by debt, reducing its appeal to potential creditors.
Strategy: Borrow against property and give the cash proceeds to family members or use it to buy property with greater asset protection.
Land trusts. These are recognized in the statutes of only six states but provide privacy and asset protection when available. Like other trusts, their assets usually are exempt from creditor claims of a beneficiary. In addition, often nothing other than the trust name needs to appear in the public record. Some states allow their land trusts to be used by non-residents if a state resident is trustee.
Strategy: If available, transfer real estate to a land trust.
LLCs. The limited liability company provides strong asset protection in most states. Many asset protection attorneys recommend LLCs as an essential tool. An alternative is the family limited partnership. A creditor, even if it succeeds in gaining an ownership share of the LLC usually cannot force distributions. The LLC also can help achieve other goals, such as providing a way to bring family members together to manage assets and create a succession process. A caveat is that all procedural rules must be followed for the LLC to be recognized.
Strategy: Transfer key assets to an LLC. A separate LLC can be created for each asset, a recommended strategy for business assets and real estate.
The umbrella. A basic form of significant protection is insurance. Homeowner’s and auto insurance provide some liability protection. A personal umbrella liability policy broadens that coverage, and $5 million of additional coverage usually can be obtained for a relatively low cost. This coverage will protect assets against claims from accidents and some personal acts, and the insurer will pay for the attorney.
Strategy: Be sure a generous personal umbrella liability policy is in place.
The simplest steps usually provide the least protection, but there are basic strategies that provide meaningful asset protection. Someone with assets of $5 million or more at risk might want to consult with an asset protection specialist and consider a series of asset protection vehicles, even offshore trusts and LLCs. Most people can provide security with the tools discussed here.
Planning is the key element of any asset protection strategy. Courts often ignore actions that occurred after a creditor’s claims already were apparent. For any strategy to be effective, it must be implemented before there is a clear threat of losing assets.