As an asset protection attorney, I get suspicious when I hear people talk about assets and investments that are “totally protected” from lawsuits and creditors. As the cliche goes, the only things guaranteed in life, are death and taxes. Protection from creditors always depends on the type of asset and the state (or country) you live in. Take an IRA for example. Any type of IRA is protected from creditors for residents of Washington state. BUT if you move to Oregon, only certain types (ERISA qualified) IRAs are protected.
If you’ve met with a financial planner in recent years, you’ve probably heard about whole life insurance policies or high cash value life insurance policies. 100% of the advisors I have met have stated that these policies are protected from creditors. Turns out, you need to slap a lawyer’s two favorite words on there: “it depends.”
Life Insurance Creditor Protection
If you look into the laws of whether life insurance is protected from creditors (called creditor exemptions), you’ll find some of the most poorly drafted legal language I’ve ever seen. There is in fact a bankruptcy case in which this law was examined and the lawyers from both sides AND the judge admitted to not understanding what the laws meant. Too many words…not enough punctuation.
Here’s a sample: “The lawful beneficiary, assignee, or payee of a life insurance policy, other than an annuity, heretofore or hereafter effected by any person on his or her own life, or on the life of another, in favor of a person other than himself or herself, shall be entitled to the proceeds and avails of the policy against the creditors and representatives of the insured and of the person effecting the insurance, and such proceeds and avails shall also be exempt from all liability for any debt of such beneficiary, existing at the time the proceeds or avails are made available for his or her own use.”
If you’re still with me, courts have found that to mean the death benefit of a life insurance policy is protected from creditors (as long as no fraud was committed in purchasing the policy). The death benefit is protected from the beneficiary’s creditors, the policy owner’s creditors, and the creditors of the insured person. That issue is fairly well settled for death benefits, HOWEVER, courts have not addressed the modern life insurance policies.
Cash Value Life Insurance
Most of the life insurance sales pitches I have sat through are focused on the cash value of the policy. The death benefit is barely an afterthought. Companies have figured out how to build life insurance policies where you put money in, it grows tax free, and can come out tax free in your retirement. High cash value is the goal. It can be a great deal, but if you are paying a premium to build a future income stream, is that income stream going to be protected from creditors? Again this will depend on where the person wanting protection lives. The laws vary by state. In Washington, John Hancock insurance writes that it is not clear whether the cash value of a policy is protected. The major court cases have addressed the death benefits, not the cash value income streams.
The Lawyer-Human’s view of it: If I invested in one of these plans and planned on receiving an income stream from that high cash value life insurance in my retirement (or otherwise), then I would NOT expect that income to be safe from creditor who might be after me.
Life Insurance Creditor Protection Solutions
The solution to protect life insurance proceeds is proper trust planning. Emphasis on “proper.” A revocable living trust is not the answer. Revocable trusts do not provide any asset protection. A life insurance policy requires an irrevocable trust to be protected from creditors. Most planners would be looking at an irrevocable life insurance trust or a domestic asset protection trust.
Smart financial planners (and smart lawyer-humans), however, know that sticking a life insurance policy in a regular irrevocable life insurance trust will mean the policy owner won’t be able to receive that sweet income stream 20 years down the road. As usual on this blog, there are some solutions for that. We will explore two options, the first of which is what attorneys have coined as a “super” irrevocable life insurance trust.
What makes it so super?
This type of trust allows the policy owner to borrow from the policy. Just like the cash value life insurance policy is supposed to work. There’s a twist, of course: the money has to be paid back to the policy, so that might not work for everybody, but your team of experts should be able to help you plan for this.
The other option is to use a domestic asset protection trust. A domestic asset protection trust is creditor protected. It also allows the owner to benefit from the income stream of the policy. There are ways to set this up so that you can access the funds in your retirement.
“I don’t plan on getting sued. Doesn’t this only matter if I get sued?”
First of all, you and me both. But it happens. It happens to business owners, it happens to doctors and dentists, it happens to people who own real estate investment properties.
It even happens to lawyers (ask us sometime and we will regale you with tales, some of which are true).
Second, having a creditor is not the same as someone suing you.
In summary, if you have “hot assets,” are in a more high risk profession, or just want to prepare for the future to the best of your ability, you should consider some advanced trust planning to protect your cash value life insurance policy and your retirement. At the very least, now you are entering into the policy aware of all potential risks!
Colin Ley is a Seattle asset protection attorney. He is also the co-founder of LayRoots along with his wife, Shreya.