While you may have spent a fair amount of time planning for expected eventualities—preparing an estate plan, for example, or implementing tax-management strategies—it can be easy to forget how important it is to plan for outcomes that are less predictable but just as important, outcomes that could affect you in the present, or your inheritors long after you are gone.
With some forethought and the help of an attorney or financial professional, it may be possible to anticipate and help protect against threats such as lawsuits, accidents, and divorce. By utilizing asset protection strategies that involve insurance, partnerships, and trusts, you may be able to provide you and your family with a layer of protection that is suited to your specific needs.
1. Assess your exposure
"There's no one-size-fits-all protection plan," says Derek Thain, a vice president on Fidelity's Advanced Planning team. "Your plan needs to be sensitive to your personal circumstances and also to the types of creditors that you are trying to protect against." For example, the risk exposure for the owner of a rental property is different from that of a medical doctor. "Based on the type of concerns," says Thain, "we can explore different potential solutions."
Depending on which state you live in, you may already benefit from certain protections. However, this can vary significantly. "Some states provide more protections than others," says Thain. "Establishing what protections you are entitled to based on your state of residence may require some research." These protections aren't always automatic. Some states may require you to be proactive to secure the protections you are entitled to. For instance, it may be necessary to file a homestead exemption with the county recorder in order to protect your primary residence against creditors and lawsuits.
Employer-sponsored plans, such as 401(k)s, and other retirement accounts, such as IRAs, may also have some degree of protection under federal or state law. Your attorney or tax advisors can help you identify what level of protection you already enjoy and what gaps may need to be filled. In general, you may need to seek additional protection for important assets such as after-tax brokerage accounts or real estate.
2. Find the right type of insurance
"Planning for protection is a multilayered process," says Thain. "But liability insurance is always the first line of defense." While automotive and homeowners insurance may cover a significant portion of your liabilities, Thain says it's wise to consider additional coverage to guard against unexpected issues. Additional coverage may also give you a little extra cushion should your existing insurance fall short of covering your costs.
Umbrella liability coverage protects against the potential financial fallout of certain types of unforeseen events that lead to property damage or injury for which the policyholder is held responsible. The coverage varies from insurer to insurer, as does the cost and availability. Simple umbrella policies may not offer all the protection some families may require, however. Doctors, accountants, and even residential and commercial landlords may want considerably more protection for their assets in case legal issues arise. Review a potential policy carefully with your insurance agent or other expert to make certain your coverage is consistent with your expectations.
3. Consider establishing a limited liability company or limited partnership
For certain assets, such as real estate, a limited liability company (LLC) or limited partnership (LP) designation may provide an effective way to add a layer of protection against creditors. "LLCs or LPs are often used for rental properties," says Thain. "They don't prevent against the liability—for example, it's still possible that the owner of a property could lose it in the event someone sues—but it does limit what assets are vulnerable to a creditor claim." Transferring the property to an LLC or an LP separates the property from the owner's other assets so that the owner's savings or primary residence might avoid being placed at risk in a tenant lawsuit. Thain suggests that individuals who own multiple properties may want to consider a separate LLC for each one, to ensure each is protected adequately.
4. Explore trust solutions to protect inheritances
"Living, revocable trusts do not provide protection against creditors," says Thain, "but parents can set up an irrevocable trust for their children as part of their inheritance plan. This may offer protection from their children's future creditors and could shield the assets from being divided in the event the children get a divorce."
A trust's ability to help protect against creditors depends significantly on how its distributions are managed. Grantors who want to provide for their beneficiaries and maintain the trust's unique protection benefits can provide their trustees with a clear standard for determining whether a distribution is truly in the best interest of the beneficiaries. It should be flexible enough to support the beneficiary's needs while restrictive enough to convey that they cannot tap into it as if it were another bank account.
To ensure that a trust is able to preserve family wealth across generations, be flexible when drafting your trust documents. Recognize that a trust set up in the present may not work exactly as you intended 2 or 3 generations into the future—whether it's because your family's circumstances have changed or because trust, tax, and estate law has evolved. Take steps to ensure that your trust has what it needs to survive and be effective: Draft a letter making your intentions clear, consider engaging a corporate trustee who can provide professional-level services and continuity, and allow for the naming of a trust protector who can modify the terms of the trust to ensure compliance.
5. Understand the trade-offs
Many asset protection strategies can significantly reduce the control and flexibility owners can exert over their assets. Depending on your circumstances, you may find that the benefits of protecting your wealth outweigh the drawbacks of giving up some control over it. Before taking action, individuals should carefully weigh their options with their attorneys and tax advisors before placing assets in irrevocable trusts, LLCs, LPs, or any other structure. That said, it's important to have your protection plan in place well before you incur any liability. "Many protection planning options must be initiated prior to any liability, claim of liability, or even anticipated liability," says Thain. "If you initiate this planning after you think liability is coming your way, it's likely too late."