What If I Get Sued? Here's a Look at Which Assets May Be Protect

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It's one of the great American fears: What if I get sued? What if creditors come after my assets?

This is a complicated area that is affected by a mix of federal and state law, with much depending on the specifics of each case and where those at risk may want to consult a qualified attorney.

Still, to get you started, here we offer a brief overview. As you ponder the subject of asset protection, it might be helpful to think of your wealth in three buckets: your home, your retirement accounts and your regular taxable account.

Your home

Depending on the state where you reside, your home may be protected if creditors win a legal judgment against you. States such as Florida, Oklahoma and Texas offer what is often called a "homestead exemption," which means your home could be fully or partially protected from creditors.

But even in states with homestead exemptions, your home may not be fully protected if you file for personal bankruptcy, if you owe state or federal taxes or if you default on your mortgage. In addition, the homestead exemption applies only to a primary residence, not to second homes.

In some states, married couples can also enjoy some protection by titling their homes as "tenancy by the entirety," which may help if only one spouse is hit with a legal judgment. One warning: If you believe you are about to get slapped with a lawsuit, don't shift your home or other assets to your spouse or children. The move could be deemed a fraudulent transfer.

Your retirement accounts

Both Individual Retirement Accounts (IRAs) and 401(k) plans offer some protection from creditors. Under the Employee Retirement Income Security Act, 401(k) plans, defined-benefit plans and other employer-sponsored retirement plans are protected from all forms of creditor judgment, whether it's the result of, say, a bankruptcy or a personal-injury lawsuit.

This blanket protection for employer-sponsored plans does not extend to retirement plans that cover only the owner of a business or the owner and his or her spouse. In those situations, the money involved should be safe in a bankruptcy, but may not be protected in other instances.

Thanks to 2005's Bankruptcy Abuse Prevention and Consumer Protection Act, up to $1 million in a regular or Roth IRA should be safe from creditors if you file for bankruptcy. Meanwhile, money from an old employer's retirement plan held in a rollover IRA may be fully protected in a bankruptcy, thanks to the protection given to employer-sponsored plans. But just in case, consider keeping your rollover IRA assets separate from your regular IRA money.

What if you don't file for bankruptcy? Depending on state law, your IRA may still enjoy some protection from creditors.

Other tax-favored accounts may also enjoy special status. Annuities and life-insurance policies are protected from creditors in some states. Money in a 529 college plan may also be protected.

While 401(k) plans and IRAs enjoy strong creditor protection, you will be vulnerable to federal tax liens imposed by the IRS. The money involved could also be grabbed by creditors when it is withdrawn from these accounts.

Because 401(k) assets should enjoy greater creditor protection than IRAs, you might leave money in your 401(k) if, for instance, you are a doctor and you are worried about lawsuits. But if this isn't such a big concern, you may find it makes sense to take 401(k) balances you have at old employers and roll this money into an IRA. That will make your finances somewhat simpler, give you access to a broader array of investments and possibly trim your investment expenses.

Your taxable accounts

While your home and your retirement accounts may enjoy some protection from creditors, money held in regular taxable accounts is much easier to reach. What to do? You might use insurance to limit your exposure.

Your auto and homeowner's policies should provide some liability coverage if, say, you hit a pedestrian or somebody trips on your lawn and breaks a leg. Make sure you promptly tell your insurer about any accident or lawsuit filed against you, or there's a risk you won't be covered.

If you want additional coverage, on top of whatever is provided by your auto and homeowner's policies, consider purchasing an umbrella-liability policy. Umbrella policies are typically purchased from the same insurer that covers your car and home. Coverage is usually sold in increments of $1 million.

How much coverage is enough? Given the frightening size of some legal judgments, a $3 or $5 million policy may not be sufficient. That said, even a $1 million policy could prove mighty useful, because it should ensure that the insurance company's lawyers get involved in your defense.

Those who have substantial assets or who own a business may want to go beyond insurance, and consider more sophisticated strategies. That might include putting part of your wealth into an asset-protection trust.

Trusts can also be used to protect money you gift to family members. For instance, if you place money in a spendthrift trust that then pays out income to your children, creditors would find it tough to lay claim to the property held within the trust. Once money is paid out to the beneficiaries, however, creditors could potentially reach the money.