Your personal assets are vulnerable to the claims of creditors, the government, individuals who might sue you, and, perhaps, an ex-spouse. What can you do to protect them? Here are sound ways to use the tax law and other means to protect your assets…

Comprehensive Approach

There’s no single action to bulletproof your assets from claims. You need to look at all aspects of your personal and business activities. Areas for review…

  • Insurance coverage. The liability limits on most homeowners’ and auto insurance policies are too low in light of the size of many of today’s personal injury awards.

    • Solution: Add umbrella coverage, which picks up where those other policies leave off. For example, a $5 million liability policy will cost about $1,200 a year. Other insurance to assess…

  • If you are a professional (such as a doctor, attorney, or accountant), carry adequate professional liability coverage, also known as malpractice insurance, with an unlimited duration. Continue coverage, even after you’ve retired from practice, usually with a one-time premium (that covers you against future claims arising from actions taken before you retired).

  • If you serve on a board of directors, including one for a nonprofit organization, make sure that the organization carries directors’ and officers’ coverage to protect you from claims arising from actions you took (or did not take) in your capacity as board member.

  • Prenuptial agreements. Those concerned with protecting property acquired prior to a marriage, or ensuring the rights of children from a former marriage, should use a prenuptial agreement. This kind of contract spells out property rights, among other things, and can protect your assets from your spouse’s claims should your marriage fail.

    • If using a prenuptial agreement to protect retirement plan assets, be sure to have your new spouse sign a waiver of his/her rights to those assets. The waiver must be signed after you get married. A prenuptial agreement does not work to protect retirement plan assets in the absence of such a waiver.

    If you are already married but don’t have a prenuptial agreement, consider a postnuptial agreement to accomplish the same goals.

  • Business organization. Anyone owning a business should consider using a type of organization that provides personal liability protection — a corporation or limited liability company can do this. However, owners should understand the limits of these legal protections. For example, a corporate shareholder who personally guarantees a third-party loan to his corporation is personally liable for the debt if the corporation fails to pay — incorporation does not give any protection in this situation.

  • State of residence. Some states offer special protection for certain assets. For example, Florida allows residents unlimited protection for personal residences. Texas and Wisconsin exempt all IRAs from creditor claims.

    • Retirement and Education Savings Plans

  • Retirement plans and IRAs. Investments held in qualified retirement plans, such as 401(k) accounts, enjoy federal asset protection (meaning they are protected against all creditors) because of the Employee Retirement Security Act of 1974 (ERISA) and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

    • Limitation: While funds in rollover IRAs are fully protected, there is a $1 million limit on protection for assets in a contributory IRA (as opposed to a rollover).

    Rollover strategy: When rolling over funds from a qualified plan to an IRA, use an account that is separate from any contributory IRA to gain unlimited protection for the rolled over amount. Do not make any additional contribution to the rollover account — continue to keep it separate from any contributory IRAs.

    Option: When leaving a job or retiring, for even stronger asset protection consider keeping funds within a qualified plan rather than rolling them over to an IRA. ERISA protection for assets held in a qualified retirement plan is “impenetrable,” meaning that creditors cannot get the funds under any circumstances. IRA funds enjoy only bankruptcy protection, so unless you go bankrupt, your funds are vulnerable.

  • Education savings plans. Funds held in 529 plans maintained by a state or eligible institution are exempt from creditors’ claims in case of bankruptcy.

    • Requirement: The account beneficiary must be the debtor’s child, grandchild, stepchild, or step-grandchild.

    Limitation: Funds contributed within one year of filing for bankruptcy are not exempt from creditors’ claims. Contributions made more than one year but less than two years before filing are protected only up to $5,000 — full exemption applies after two years. Note: Your state may offer greater protection for 529 plan assets than allowed under the federal bankruptcy law, and you can choose this state protection over federal protection.

    Trusts

    Assets held in a trust for a beneficiary generally are protected from creditors’ claims — if the right type of trust is used. Options…

  • Spendthrift trust. This is a trust that includes a clause preventing undistributed income and principal from being used to satisfy the claims of a beneficiary’s creditor. For example, the beneficiary cannot assign his interest in the trust to a creditor to satisfy a debt. Usually, this type of trust is used only for a beneficiary other than the person who sets up the trust, such as that person’s spouse, child, or grandchild.

    • Caution: Asset transfers to a trust may be subject to gift tax (depending on the size of the gifts and who the beneficiary is).

  • Domestic asset protection trust. This trust is designed to protect the assets of the trust’s creator from claims of his own creditors. Only certain states allow them — Alaska, Delaware, Nevada, Rhode Island, and Utah. Whether a resident of another state can protect assets by setting up a trust in one of these states has yet to be tested in court, so, for now, asset protection trusts probably work best for residents.

  • Foreign trust. Set up in jurisdictions that do not enforce judgments of US courts, these trusts are not necessarily unreachable. Before using them, discuss asset protection with an attorney who specializes in the subject.

    • Long-Term Care

    Needing long-term care because of accident-related injuries or chronic illness can be financially devastating. AARP estimates that 60% of those over age 65 require some type of long-term care during their lives. Many people don’t realize that standard medical policies and Medicare do not cover this type of care, which can quickly wipe out a lifetime of personal savings.

    Solution 1: Those with a sizable chunk of assets to protect (generally, $500,000 or more) should consider buying a long-term-care insurance policy. For federal income tax purposes, part of the premium is a deductible medical expense (the portion depends on current age). State law may provide additional tax breaks (for example, in New York, there’s a 20% tax credit for all such premiums).

    Solution 2: Those with more modest assets, who cannot afford long-term-care premiums, should consider transferring almost all their assets (other than assets exempt under Medicaid) to family members in order to qualify for Medicaid, which does pay for long-term care.

    Plan ahead: Transfers made within 60 months of a Medicaid application are taken into account in determining eligibility and may prevent this government assistance.

    Those with family histories of chronic diseases that typically require long-term personal care not covered by regular medical insurance policies, such as Alzheimer’s disease, should discuss long-term planning with a knowledgeable elder law attorney. (Find one near you through the National Academy of Elder Law Attorneys Web site, www.naela.org.)

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