a significant amount of taxes you cannot pay to the IRS, they can take your home notwithstanding the state-allotted homestead exemption.
Practical example of how the homestead exemption would work if sued. Assume an athlete is sued for negligence and a jury verdict comes back for $1,000,000 over any insurance coverage the may be available. Further, assume that the athlete is single and has a home worth $1,000,000 with $500,000 in equity.
If the athlete lived in a state with an unlimited homestead exemption, the creditor, through the collection process, could not force a sale of the $1,000,000 home to satisfy the judgment.
If the athlete lived in a state with NO homestead exemption, the creditor, through the collection process, could potentially force a sale of the $1,000,000 home to satisfy the judgment.
If the athlete lived in a state with a $50,000 homestead exemption, the creditor, through the collection process, could potentially force a sale of the $1,000,000 home to satisfy the judgment. In this example, the creditor could receive all the proceeds from the sale of the house above $50,000. That first $50,000 is the exempted amount and stays with the athlete.
Having a homestead exemption in most states does very little good for a high-end client with the potential for million-dollar creditors. States with an unlimited exemption are the exception.
If you would like to know what the laws are with your state’s homestead exemption, please see a local attorney or feel free to give one of the authors a call. We would be happy to give you the specifics of your state.
Life Insurance and Annuities
All assets are not created equal. This is proved by the fact that life insurance and annuities in many states are, by state law, specifically protected from creditors.
Like many laws, the laws protecting life insurance and annuities are rooted in public policy. The legislators in some states believe a life insurance and/or annuity benefit is essential for citizens and/or their families to maintain at least a minimum level of financial well-being and, most importantly, from becoming wards of the state.
The state’s interest to avoid paying for the indigent is tempered by a creditor’s right to collect a legal debt; but as you can understand from the government’s point of view, it is always better for someone to support themselves than for the government to dig deep into their pockets to support even more needy citizens.
State laws. Like the homestead exemption, state laws vary widely when it comes to protecting life insurance. Some states, Florida and Texas, give an unlimited exemption to life insurance policies that have cash value in them, and some states give none. South Carolina, for example, provides a limited protection for cash value in the amount of $4,000.
The death benefit in almost all jurisdictions is exempt from creditors who would be left to sue the estate of the deceased debtor. Hawaii specifically exempts the death benefit and the cash surrender value of policies provided that the policy is payable to a spouse of the insured, or to a child, parent, or other dependents of the insured.
Know whether or not your state exempts some, all, or none of the cash surrender value in your life policy, and if the state exempts the death benefit. If you live in a state where it is protected, funding a properly structured cash value life insurance policy as a wealth building will be a good way for many athletes to create a safe tax-free wealth building tool.
Annuities
Annuities are treated similarly to life insurance by each state when it comes to being treated as a protected asset. The main difference is that annuities are designed to pay out a stream of income at some point, whereas a lump sum death benefit is paid with a life insurance policy.
Some states will exempt all the cash built up in an annuity and the annuity stream, and some states will not protect either. Then there are the hybrid states which protect all of one and not the other, or some of each.
Florida, not surprisingly, exempts the cash in an annuity and the stream of income from any annuity. Pennsylvania generally permits the exemption of only $100 per month of the proceeds from an annuity, and North Carolina doesn’t exempt any proceeds that come from an annuity. Some states allow what is reasonably needed to live on as an exemption from an annuity.
Retirement Plans
In 1990, the United States Supreme Court made clear that a creditor (outside of bankruptcy) could not reach “ERISA qualified” plan assets. In 1992, the issue of whether an ERISA qualified plan was subject to bankruptcy was raised; and the answer from the Supreme Court was, “No.”
What is an ERISA qualified plan? Unfortunately, there is no definition of an ERISA qualified plan in the IRS code or under the Employment Retirement Income Security Act (ERISA). The Supreme Court did fashion its own definition and the factors to be considered are:
1) The plan must be subject to ERISA;
2) The plan must be qualified under Section 401 of the Internal Revenue Code;
3) The plan must contain the anti-alienation provisions which are required under both the IRC and ERISA.
Instead of explaining in detail what the above requirements mean, we instead will list the plans you will know that are ERISA qualified. In general, however, the plan must cover employees and cannot discriminate in favor of highly compensated employees.
1) 401(k) Plan
2) Profit Sharing Plan
3) Money Purchase Plan
4) New Comparability Plans
5) Defined Benefit Plan
6) 412(e)3 Defined Benefit Plan
Be sure to check with your pension plan provider (any listed above) to verify your plan is in compliance with ERISA laws. If your plan happens to fall out of compliance for whatever reason (and there are many plans that are not in technical compliance), then it will be left up to the courts and possibly the IRS to determine if your plan qualifies for exemption from creditors.
Non-ERISA Plans and IRAs. Simplified Employee Pension plans (SEPs) and Keogh plans are not specifically protected by federal law. The determination of whether SEP and Keogh plans are protected will be left up to each state to determine. If you have a SEP or Keogh plan that includes multiple employees and is funded in a non-discriminatory manner similar to ERISA governed plans, you will have a good argument for why those plans should be protected (especially in states like Florida and Texas, which have already exempted life insurance and annuities from creditors).
An IRA is not considered an ERISA qualified plan; and, therefore, the assets in an IRA have no federal protection from creditors.
Individual states, however, can and have protected IRAs in full (26 states) or in part. In states where IRAs are not specifically protected, it is up to the state courts to determine if, in a particular case, the IRA asset, in full or in part, is protected.
Recent Supreme Court Case. There has been a recent Supreme Court case addressing the issue of asset protection
