Recently, a pharmaceutical executive went out for the night with his wife to see a Broadway show, leaving their three teenagers alone for a few hours. While the parents were gone, the kids hosted a party with alcohol. A guest drove home intoxicated, swerved into another car, and caused a head-on crash leaving the other driver permanently injured. The victim’s family sued the pharma executive. The executive was found liable and ordered to pay upwards of $2 million for medical costs, lost wages, and attorney fees. It’s a sad story all around, but in our litigious society, this scenario is not uncommon.
This example underscores the two main reasons why executives need a personal risk management plan: accidents happen and lawsuits are expensive. Without a personal risk management plan, executives can be exposed to costly legal settlements which could drain their bank accounts and/or cost them future earnings. Here are three strategies executives can use to help shelter their assets from potential lawsuits.
1. Carry an Umbrella (Liability Policy)
A simple and effective way to prevent depleting your assets in the event of a lawsuit is by having an umbrella liability insurance policy. If you’re sued for damages above your car, homeowners’, or other insurance policies, an umbrella policy can pay what you owe. For example, if you are involved in a vehicle accident and sued for $1 million in damages but you only have $500K of auto liability coverage, the umbrella can pick up the difference.
I usually recommend my clients have umbrella coverage equal to their net worth (assets minus liabilities). A client with $5 million in an investment account but carrying a $1 million mortgage, should consider $4 million of umbrella insurance as a starting point. However, the cost to insure the additional $1 million might not be far off, so it may be worth it for peace of mind to insure the full $5 million.
As for cost, I usually find umbrella liability to be reasonably priced for the coverage limits. For example, a $5 million umbrella liability policy may cost between $2K and $5K a year, depending on where you live and other circumstances like the number of vehicles you own or if you have multiple houses.
I usually stick to the higher-rated insurance carriers which may be costlier, but my clients typically don’t mind paying up if they can purchase from a carrier with better claims-paying history. It’s a good idea to check with your existing insurance carrier too, as there may be discounts if you bundle an umbrella with your home and auto. Umbrella policies may also provide coverage if you are sued for slander and/or libel.
There are limitations, of course. Umbrella policies won’t pay for your injuries or damage to your belongings. However, given the benefits, having a proper umbrella policy is a good first step in building a personal risk management plan.
“You might be thinking, “That’ll never happen to me.” The truth is most people probably don’t see it coming. Accidents happen, mistakes are made, and lawsuits are filed….Why risk it?”
– Michael AloiTweet it
2. Keep Savings in the Right Accounts
Some investment accounts have greater creditor protection than others, which can come in handy in the event you are sued and declare bankruptcy. It may be harder for creditors to access funds in ERISA-governed retirement accounts such pensions, 401(k) plans, and some 403(b) plans—except in cases you are found guilty of a crime and other limited exceptions according to Equifax, a leading credit management firm.
Even if you accumulated millions of dollars in Employee Retirement Income Security Act (ERISA) accounts, there is no cap on the protection amount. For this reason, executives concerned about personal exposure in the event of a lawsuit may want to max out their ERISA plans like their 401(k). Starting in 2023, executives can contribute $22,500 to their workplace 401(k) and, if eligible, an additional $7,500. Depending on your plan’s rules, there may be a way to save even more if the 401(k) allows for after-tax contributions.
But be careful: Not all employer-offered retirement plans are governed by ERISA, and if not, they will lack the same creditor protections. For example, deferred compensation plans, which can be a way to defer a part of your bonus and delay income taxes, may or may not be an ERISA-governed plan. It’s best to check with your employer.
The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 provides federal protection for contributions and earnings in Individual Retirement Accounts (IRAs) in the event of bankruptcy up to a maximum limit indexed for inflation every three years, currently $1,512,350. Rolled-over dollars from a 401(k) to an IRA are not subject to the limit.
Exceptions include if you use the IRA for a prohibited transaction. State laws can vary, some have higher limits than the federal. Even if a state doesn’t have its own laws specifically protecting your IRA in the event of bankruptcy, you still have federal protection up to the applicable limit.
Cash-value life insurance, such as whole life, universal, or variable life insurance, can provide creditor protection. BAPCPA provides federal protections for policyholders provided the insured is the debtor or the debtor’s spouse. Limits apply. Many state laws provide additional creditor protections. It’s best to check with a qualified professional.
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3. Layer Protection With LLCs and Trusts
Beyond saving in ERISA accounts and having an umbrella liability policy, an executive can attain additional asset protection by owning assets in a limited liability company (LLC) and/or certain trusts.
An LLC is an effective way to limit liability to the assets owned by the LLC. We see this mostly with rental real estate. If a client owns multiple rental properties but each is owned by a separate LLC, any damages can be limited to the assets in the LLC rather than the aggregate estate.
There are exceptions. Most notably, an LLC does not protect from personal liability. To help keep the LLC separate from your personal assets, you won’t want to mix personal assets with an LLC but maintain separate records and accounts. There is additional complexity involved when using an LLC, notably the start-up costs, ongoing filing requirements, and fees. It’s best to check with a qualified attorney and/or tax advisor in your state before implementing.
A trust is another useful tool in estate and tax planning and can also help protect assets from unwanted creditors. To be an effective asset protection tool, trusts must have a “spendthrift clause” which prevents the beneficiary of a trust from voluntarily or involuntarily transferring any current or future rights from the trust. Assets in an irrevocable trust provide the most asset protection, the caveat being the assets are irrevocably assigned to the trust, meaning you technically can’t access them as easily as, say, a revocable trust.
A trust is irrevocable when the grantor—in this case, the executive—can’t change the terms of the trust. A third-party trustee is responsible for managing and overseeing the trust. Trusts, like LLCs, involve legal costs and additional complexity but can be an important tool in the asset protection toolbox. It’s best to consult with a qualified tax advisor before proceeding.
You might be thinking, “That’ll never happen to me.” The truth is most people probably don’t see it coming. Accidents happen, mistakes are made, and lawsuits are filed. The new year is a great time to take stock of your financial planning—investments, insurance, estate planning—and to think through your own risk management plan. Why risk it?
Disclaimer: Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Summit is not responsible for hyperlinks and any externally referenced information found in this article.