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Protect Your Nest Egg: Your Life Insurance Cash Value Could Be Taken from You

Roger McClure May 18, 2016

Mary and Fred Jones’ highly rated financial advisor created a comprehensive investment and tax plan for them. They planned to retire soon and wanted to be sure everything in their complicated life was covered. They owned a home, several retirement accounts, a number of investments, other savings and life insurance. They even had a long term care policy to pay nursing home expenses if needed. They were not multi-millionaires, but to their astonishment, all of their assets, including the cash value in their life insurance and home equity, totaled about $1,000,000.

Their financial advisor crunched the numbers and found a way for Mary and Fred to increase their retirement income and decrease their taxes on their income and future social security payments and to eliminate payments for their separate long term care insurance contracts. A key part of this plan was for Fred and Mary to change their life insurance to provide a stream of income in retirement. If they borrowed against their policy, they could get tax-free funds as long as the policy stayed in place. Also, by placing a rider on their new life insurance policy to pay for nursing home or home health care if they were disabled, they could drop their payments on their expensive long term care insurance.

If Mary and Fred never used the long term care insurance rider, their children stood to inherit a substantial death benefit without any income or estate taxes from their parents’ life insurance contract. Under their old long term care insurance coverage, the insurance company had no obligation to refund any funds if Mary and Fred never needed nursing home care, so sadly all their payments into that plan were effectively a loss to their estate if never used.

The state Mary and Fred live in did not tax estates of their size and they were well below the $5.45 million per person estate tax exemption under federal taxes for  2016.

They were satisfied. Their financial planner had created a fine-tuned pre-retirement plan for them, with more income and fewer taxes than before.

Or did he?

Several weeks later, after a busy day at work, Fred and Mary met for dinner to celebrate their imminent retirement; they had a little too much wine. After all, it was a Valpolicella from Verona, Italy, rated 92 out of 100 by Wine Spectator, smooth and delicious and their favorite wine. On the way home, they had an auto accident and were both found at fault, because Mary let Fred drive her car after he drank too much. The jury took a disliking to Fred who could be arrogant and unsympathetic at times. The question of driving under the influence didn’t help his case, either. Their case went down in flames. The Jones have only $500,000 maximum liability coverage on their auto insurance, so after their insurance company paid the full $500,000, Fred and Mary still owed $400,000 on the judgement against them.

The attorney collecting the $400,000 couldn’t seize their retirement accounts because their retirement accounts are protected under federal law. However, the creditor was able to seize the $350,000 cash value of their life insurance policy.

Losing that $350,000 was bad enough, but it got worse. A lot worse.

Because the funds Fred and Mary needed to pay future insurance premiums were gone, they couldn’t fund their new life insurance plan or its long term care rider. The plan to slowly release money from their insurance policy to make for a comfortable retirement evaporated, along with their retirement dreams. Fred and Mary could not retire and their whole financial plan blew up.

This disaster was not the fault of their financial planner who is not responsible for Fred and Mary’s asset protection. Who knew? Most people think that their life insurance policy is protected. But maybe not; it depends on where you live.

Protecting life insurance assets interweaves federal bankruptcy law, federal pension law, and state law in a complex skein of laws. Bankruptcy law is not likely to apply if you can pay the debt from available assets. The life insurance policy is not likely to qualify as a pension protected by federal pension law.

If Fred and Mary lived in Florida, it is likely their cash value would have been protected under Florida law. If they lived in Virginia, cash value is usually not protected. In Maryland, it depends on who is the insured, who is the beneficiary and who dies first. In the District of Columbia, the death benefit for their children could be protected, but not usually the cash value of the life insurance policy where Fred and Mary are the primary beneficiaries. And some state statutes are so garbled that the attorneys and the Judge can’t decipher them.

Confused yet? Jay Adkisson, one of the leading asset protection attorneys says that “probably no where is the law relating to exemptions (from creditors) more confusing than that relating to life insurance proceeds”

Was there something Fred and Mary could have done to asset protect their plan?

Maybe. If Fred and Mary lived in Virginia or one of the dozen states that allow it, they could have set up a domestic asset protection trust (DAPT) naming themselves as beneficiaries. Of course, they would have had to set up the DAPT prior to the accident. With a DAPT they would have been protected against the later auto accident. Depending upon state law, after two to five years, they would also be protected against any debts they had before they set up the Domestic Asset Protection Trust.

To make a domestic asset protection trust work, you cannot intend to defraud or delay collections from a known existing creditor. It is paramount then to set up the DAPT before problems arise. You also have to comply with the requirements of your state statute for an independent trustee and the rules for investment and distribution of the funds in the DAPT.

If your state does not protect the cash value of your life insurance and does not have a DAPT statute, you would still be ahead by setting up an irrevocable trust created in your state, or to provide more protection, a trust set up in an offshore jurisdiction to provide enhanced protection for your life insurance.

Life insurance can be tremendous asset for increasing income, reducing taxes and insuring a better future for your loved ones. But it can be vulnerable if it is not protected well. Protect the cash value in life insurance policies; establish the right kind of trust…before it’s too late.

Contact us for a review of your options to protect your nest egg. Call.