Maximizing Exempt Assets
In the following chapters, we will explain a number of legal entities and techniques we use to protect the assets of our Doctor clients. This chapter on maximizing exempt assets precedes the following chapters because, in our view, clients should always reasonably maximize their use of exempt assets before moving on to legal tools, legal entities, and other techniques.
Despite their superiority to other asset protection strategies, exempt assets are not adequately used by most Doctors. This chapter will explain why many advisors don’t recommend exempt assets as often as they should. Then we will discuss all of the exempt assets that can be valuable components of a comprehensive financial plan. Throughout the book, you will revisit many of these exempt assets as they provide additional benefits to asset protection. In a later Lesson, you will learn how sophisticated Doctors save time and money by leveraging exempt assets that offer additional benefits. For now, let’s begin discussing why exempt assets are considered the “best” asset protection tool and then discuss the reasons why they remain underutilized in asset protection planning.
Exempt Assets: The “Best” Asset Protection Tools
We consider exempt assets to be the “best” asset protection tool for the following reasons:
1. No legal/accounting fees
Most of the tools in subsequent chapters involve the creation of legal entities that require set up and ongoing legal fees, state fees, accounting fees, and even additional taxes. Using the exempt assets described in this chapter involve none of these significant costs and affords better protection as well.
2. No loss of ownership or control
The legal tools of the following chapters typically require giving up some level of ownership or control to family members or even third-party trustees. By using exempt assets, you can own and access the asset at any time while enjoying the highest (+5) level of protection.
3. Superior Protection
The legal tools explained later offer protection that ranges from (+1) to (+5). Exempt
assets always enjoy the top (+5) protection up to their exempt amount.
Why Exempt Assets Are Underutilized
Given the clear benefits of exempt assets, one would think that exempt assets would be preferred over other tools in an asset protection plan. Surprisingly, this is often not the case. The reason for this may be that most asset protection planning is implemented by an attorney who is not familiar with the financial tools a multi-disciplinary team could offer.
There are various planning pitfalls that can arise when you do not have the benefit of a coordinated, multi-disciplinary team to help implement your plan. Attorneys generally do not understand many of the exempt asset classes, such as cash value life insurance and annuities. You cannot expect an advisor to recommend something he doesn’t understand.
This doesn’t mean that one attorney could not recommend an adequate asset protection plan. What it does mean is that the plan created by one attorney may not be efficient, because the plan may be limited only to legal solutions. If you were more skeptical, you might point out that attorneys are generally not licensed to sell such financial products. Is it unrealistic to expect an attorney to have a bias against the use of exempt assets for asset protection when the implementation of those assets does not require any legal work?
Is it unreasonable to expect attorneys to focus their asset protection recommendations around the use of legal documents that may generate thousands of dollars in legal fees? This is not a conspiracy against, nor is it an indictment of, attorneys—we, as an author group, include a number of attorneys. However, we are attorneys who appreciate multi-disciplinary planning and recognize the value of financial, as well as legal, solutions. The reason we wrote this book with attorneys and the consultants of the OJM Group is that we believe 100% in a multidisciplinary approach to asset protection planning.
The lesson here is simple. Your asset protection plan, like the rest of your financial plan, MUST be handled by a coordinated, multi-disciplinary team that carefully considers all planning options to help you efficiently achieve your goals. The absence of exempt assets in a plan is always a warning sign that the planning is not coordinated.
Federally Exempt Assets
Federally exempt assets are those assets that are protected under federal bankruptcy law. Federal law protects certain assets from creditors and lawsuits if the defendant is willing to file bankruptcy to eliminate the creditor. In a Chapter 7 Bankruptcy, the debtor will be able to keep any assets that federal law deems exempt. The two significant asset classes that federal law protects are qualified retirement plans (QRPs) and IRAs. The term “qualified” retirement plan means that the retirement plan complies with certain Department of Labor and Internal Revenue Service rules. You might know such plans by their specific type, including profit sharing plans, money purchase plans, 401(k)s or 403(b)s. IRAs are very similar to such plans with several technical differences, and are now given exempt status under the federal law as well.
While this protection is (+5), you must recognize that this federal protection only applies if you are in a bankruptcy setting. If you were simply sued and a creditor was trying to take the funds in your pension or IRA, bankruptcy protection would not apply. You would have to take the step of filing for bankruptcy to shield the asset. This might be too great a cost for the protection.
If you do not file for bankruptcy, this federal protection would not apply. The amount of value in the QRP or IRA that would be protected outside of bankruptcy would be governed by applicable federal and California state law.
Let’s look at the applicable federal law first. In 1992, the U.S. Supreme Court, in Patterson v. Shumate, 504 U.S. 753 (1992), held that a participant’s interest in an ERISA (Employee Retirement Income Security Act)-qualified pension plan was excluded from the participant’s bankruptcy estate and could not be used to satisfy the participant’s creditor claims.
Outside of bankruptcy, if a Doctor’s retirement plan is an ERISA-qualified pension plan, so the logic goes, creditors should not be able to reach that asset either.
In determining whether a Doctor’s QRP or IRA benefits are protected from creditor claims in California depends on the type of plan and whether the plan is covered by ERISA.
If the retirement plan is a QRP covered under ERISA (such as pension plans, profit sharing plans, 401(k) plans and stock bonus plans) a Doctor’s benefits under the plan are protected from the claims of creditors. Exceptions include a Qualified Domestic Relations Order (QDRO, pronounced “quadro”) issued by a court during divorce proceedings and tax claims asserted by the IRS. However, a QRP that covers only a sole proprietor (and his or her spouse), or the sole owner of a corporation (or his or her spouse) is not covered by ERISA. Such “owner only” QRPs, even though qualified under the Internal Revenue Code, are not covered under ERISA and may not be exempt from creditors.
For non-ERISA QRPs and IRAs (which are not subject to ERISA), creditor protection is provided by California Code of Civil Procedure Section 704.115(b). This section provides that “all amounts held, controlled, or in the process of distribution by a private retirement plan, for the payments of benefits as an annuity, pension, retirement allowance, disability payment or death benefit from a private retirement plan are exempt.” Additionally, the section provides in subsection (d) that “after payment, the amounts described in subdivision (b) and all contributions and interest thereon returned to any member of a private retirement plan are exempt.”
Let’s define what a private retirement plan, as used in the statute, is. Section 704.115(a) provides that private retirement plan means: “(1) Private retirement plans, including, but not limited to, union retirement plans. (2) Profit-sharing plans designed and used for retirement purposes. (3) Self-employed retirement plans and individual retirement annuities or accounts provided for in the Internal Revenue Code of 1986, as amended, including individual retirement accounts qualified under Section 408 or 408A of that code, to the extent the amounts held in the plans, annuities, or accounts do not exceed the maximum amounts exempt from federal income taxation under that code.”
What this means in plain English is that all benefits held in, and all distributions from, a private retirement plan are exempt from creditor claims. However, the exemptions for self-employed retirement plans and IRAs only applies to the extent the amounts in the plan or IRA are necessary to provide for the support of the Doctor after retirement and for the support of the Doctor’s dependents, taking into account all resources that are likely available for such support when the Doctor retires. Consequently, when determining whether benefits in self-employed retirement plans or IRAs are exempt from a Doctor’s creditors, a court will undertake a facts and circumstances analysis by looking at the amount of the debt, the amount in the plan or IRA, the age of the Doctor, the Doctor’s earning capacity, the Doctor’s other assets, the Doctor’s ability to replenish the amount in the plan or IRA before retirement and other factors.
State Exempt Assets
State exemption leveraging is a fundamental part of a financial plan and one which every Doctor client should take seriously. The most significant state exemptions are:
1. Qualified Retirement Plans (QRPs) and Individual Retirement Accounts (IRAs)
2. Primary Residence (or Homestead)
3. Life Insurance
Qualified Retirement Plans and IRAs:
Outside of bankruptcy, protection for QRPs and IRAs is provided by California Code of Civil Procedure Section 704.115, as discussed above. To recap, if a retirement plan is a pension plan covered by ERISA and meets the qualifications under the Internal Revenue Code, a Doctor’s benefits under the plan will be protected from creditors’ claims. Even if the plan is not covered by ERISA, but meets the definition of private retirement plan as described in the statute, a Doctor’s benefits will be exempt from creditors’ claims unless the plan is a self-employed retirement plan or IRA (including a rollover IRA), in which case the benefits will be exempt only to the only necessary for the support of the Doctor and the Doctor’s dependents at retirement.
Primary Residence: Homestead
Many Americans consider the home to be the family’s most valuable asset. You may have thought you knew the laws that protect your home. Perhaps you have previously heard the term “homestead”, and assumed that you could never lose your home to bad debts or other liabilities because of this homestead protection. The reality is that few states provide a total (+5) shield for the home. This is certainly true in California.
Life Insurance: Protected Everywhere
All 50 states have laws that protect varying amounts of life insurance. In California, Code of Civil Procedure Section 704.100 pertains to life insurance. The Section provides as follows:
“(a) Unmatured life insurance policies (including endowment and annuity policies), but not the loan value of such policies, are exempt without making a claim.
(b) The aggregate loan value of unmatured life insurance policies (including endowment and annuity policies) is subject to the enforcement of a money judgment but is exempt to a small amount. If the judgment debtor is married, each spouse is entitled to a separate exemption under this subdivision, and the exemptions of the spouses may be combined, regardless of whether the policies belong to either or both spouses and regardless of whether the spouse of the judgment debtor is also a judgment debtor under the judgment. The exemption provided by this subdivision shall be first applied to policies other than the policy before the court and then, if the exemption is not exhausted, to the policy before the court.
(c) Benefits from matured life insurance policies (including endowment and annuity policies) are exempt to the extent reasonably necessary for the support of the judgment debtor and the spouse and dependents of the judgment debtor.”
The easiest and cheapest way to achieve the highest level of asset protection is to use exempt assets. For this reason, it makes sense that every Doctor who is interested in asset protection should attempt to maximize his or her use of exempt assets. However, to use exempt assets properly within a comprehensive financial plan, you may need insurance product, home loan, qualified plan, tax and asset protection expertise. This is another example of why you need a multi-disciplinary team to help you achieve your financial goals.
Practically, the laws in California usually do not afford you enough exemptions to place every dollar of your wealth into exempt assets. For this reason, you will have to utilize legal strategies as part of your asset protection planning. The next chapter will discuss the two most common asset protection tools—the Family Limited Partnership and the Limited Liability Company.