Protecting Your Assets

April 20, 2005

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

As your net worth increases, so might your level of concern about protecting your assets. A strategic asset protection plan can help

Legal and ethical asset protection is not about hiding what you own from bona fide creditors, or trying to evade legitimate and lawful obligations. Asset protection is about legally and ethically avoiding loss and unnecessary taxation, planning for illness, disability and mortality, and protecting yourself from the actions of others.

Chances are you already have property, casualty and liability insurance to protect your car, home and other possessions. You probably have life, health and disability insurance to preserve your financial assets against loss of life, catastrophic illness or incapacity. When it comes to your investment portfolio, hopefully you've diversified across and within asset classes to help protect against risk. And perhaps you've even employed portfolio hedging techniques.

 What other steps might you consider to protect your assets? We can only scratch the surface here, but following are some ideas that might prompt further discussion between you and your attorney and/or CPA.

Liability insurance

Home and auto insurance policies typically come with a specific amount of liability coverage. Is it enough for you? Probably not. Consider additional coverage with a personal "umbrella" policy. Depending on your circumstances, you should be able to buy a $1 million personal umbrella liability policy for between $200 and $400 per year. The next million dollars of coverage typically comes at an even lower additional premium.

Personal umbrella policies don't cover work-related lawsuits, so if you're in a professional practice you should also consider professional liability coverage for such things as malpractice, errors and omissions, contractual disputes and so on. Businesses with physical storefront locations and employees need to consider a whole host of liability issues, including accidents and personal injury, defective product sales, wrongful discharge and more. The way you structure your business entity can also impact your personal liability (see below).

Asset titling and placement

Where your assets reside, and how they're titled, can help limit unwanted access by third parties.

• Titling. Asset titling (e.g., giving sole title to a low-risk family member) can help protect what you own. However, be careful your actions don't lead to unintended consequences. For example, placing adult children on your accounts as joint tenants with right of survivorship may be a convenient way to help you manage your affairs and avoid probate. But if one of the joint tenants runs into financial trouble, his or her creditors may gain access to your account (granting a limited power of attorney instead could solve this issue).
  
  Explore the titling options for your state of residence (individual, joint tenancy, tenants in common, tenants in the entirety, community property titling, etc.) within the context of your overall financial plan.
  
• Retirement plans. Federal law (ERISA and IRS rules) generally protects from creditors 401(k)s and other qualified retirement plans held in trust. Non-qualified deferred compensation plans, however, are unfunded, unsecured promises to pay. Your creditors may not be able to touch the money, but it's possible your company's creditors might be able to. Although the level of IRA protection differs under various state laws, a 2005 U.S. Supreme Court ruling (Rousey v. Jacoway, 03-1407) shields traditional IRA assets in bankruptcy when the funds are found reasonably necessary for the account holder's or his/her dependents' support. Furthermore, federal bankruptcy reform signed into law in 2005 protects from creditors—for any reason—up to $1 million held in traditional and Roth IRAs.
  
• Life insurance and annuities. As with IRAs, state law generally applies here. Cash value in a life insurance policy typically receives better protection than money in a deferred annuity—though once annuitization has begun, the annuity is removed from your personal balance sheet in exchange for the promise of a monthly payment, effectively limiting access by outside parties.

Trusts and family partnerships

An in-depth discussion of trusts and partnerships is well beyond the scope of this article. Be aware that while a revocable living trust can be a great way to manage your estate and avoid probate, it provides little to no protection from creditors. However, a properly drafted irrevocable trust or family limited partnership can help transfer and protect family assets. Likewise, a charitable remainder trust (CRT) can afford a significant degree of asset protection.

Asset protection trusts: domestic vs. offshore

Some affluent individuals have used what's known as a "self-settled spendthrift trust" to protect their assets. A spendthrift clause keeps the beneficiary of a trust from accessing or transferring his or her interests in the trust. But it also generally prevents the beneficiary's creditors from getting their hands on the trust's assets.

In the case of a self-settled spendthrift trust, the grantor and the beneficiary are one and the same—and as the grantor, you have access to the trust. Sounds great, except until 1997 no state would allow a self-settled spendthrift trust to operate under law. Presumably, it was considered a bad idea to allow a person to put assets into a trust, out of the reach of creditors, and still allow that person to benefit from the assets.

Beginning in 1997, however, such trusts were allowed to operate in Alaska and Delaware. Since then, several other states have jumped on the bandwagon. Asset protection trusts set up in these states (you don't need to reside there) could be a viable alternative to offshore trusts, which tend to be more complex and expensive.

How well domestic asset protection trusts stand up to attack from creditors will likely be tested in the courts in the years to come. Be sure to consult with your attorney and/or CPA on the pros and cons of this sophisticated asset protection strategy.

Other issues

• Small business planning. A sole proprietorship or simple partnership may be easiest to set up and operate, but provide little in the way of protection for your personal assets. Traditional C-corporations offer limited liability but are taxed at the entity level. A better choice might be an S-corporation or Limited Liability Company (LLC)—these offer the benefits of limited liability as well as "pass-through" income. An S-corp or LLC may also make it easier to implement a business succession plan, protecting your business assets even after you're out of the picture.
  
• Divorce. You don't need to be a movie star to consider a prenuptial agreement. Ideally, a husband and wife would operate as one economic unit, but everyone's different. If one or both parties come into the relationship with significant sole and separate property, a prenuptial or cohabitation agreement could make sense.
  
• Incapacity. A durable power of attorney can help make sure your assets are protected and managed by someone you trust in the event you become incapacitated.

A word of caution

There's nothing unethical about lawfully protecting what's yours. But making oneself insolvent (not to be confused with legitimate bankruptcy) to avoid a legal obligation or skirt the law is more than just unethical, it's unlawful. Most states either have their own fraudulent transfer laws or have adopted some form of the Uniform Fraudulent Conveyance Act (UFCA) or the newer Uniform Fraudulent Transfers Act (UFTA). Under these statutes, making a transfer with the intent to hinder, delay or defraud a creditor (or potential creditor) can result in fines and/or imprisonment.

Also, be wary of offshore trust promotions that tout potential income tax savings. Offshore trusts and accounts sound exotic and sophisticated (think of the fabled "Swiss bank account"), but keep in mind that the federal government (not to mention the various state income tax authorities) taxes its citizens on income from all sources, worldwide.

Frankly, there's no shortage of asset protection and income tax scams floating around. If a strategy sounds too good to be true, it probably is. Skip the seminars and do-it-yourself books. Seek the counsel of your trusted professional advisors.

Take a team approach

When putting together a plan to protect your assets, it's smart to have all your professional advisors working off the same page. For example, you might consult a CPA to explore the tax and business aspects of what you hope to accomplish, have your attorney draft the appropriate documents, and then turn to your Schwab representative for help with implementation, custody, titling, investment management and so on. And always be sure to keep the lines of communication open between all your team members.