In most states, life insurance contracts where a spouse or child is the beneficiary are exempt from the claims of creditors without any dollar limit. In a few states, the same protection is given to annuity contracts. But, if the annuity contract is part of an ERISA qualified plan, it will be exempt in most states. A Swiss annuity contract will be protected from the claims of your creditors if your spouse or children are the beneficiaries or if there is an irrevocable beneficiary. Those are the only generalizations that I can make about the asset protection aspects of annuity contracts and life insurance contracts. The rest of this report elaborates on these generalizations.

Where an annuity is being paid to a named beneficiary over their life expectancy, the cash value now belongs to the insurance company and the insurance company has an obligation to pay the annuity income for the lifetime of the annuitant or for some term of years. The annuitant no longer has the power to cancel the contract and take out the cash value. If there are any contracts that do allow the annuitant to cancel the contract and take the remaining cash value, then that contract should be subject to the same rules as one that is not yet converted into a lifetime income.

Any discussion here about the transfer of the cash values of an annuity or life insurance contract to someone else (or even to some other entity) assumes that you are not making a fraudulent conveyance to hinder, delay or defraud your creditors.

If you have the right to name the beneficiary, to cash in the policy or to borrow against the cash value of the policy, then you are considered the owner of the contract. Unless that value is protected by state law (as discussed later), you can be forced by law to liquidate the contract and make the proceeds available to your creditors. The most effective way to protect money in a life insurance or annuity contract is to make someone else the owner of the contract.

That might be a spouse or even your children. When you do that with an existing contract, you are making a gift. The value of the gift is based on the cash surrender value of the contract. If the gift is to anyone other than a spouse, you may have to file a gift tax return. You may then use up part of your lifetime estate and gift tax exemption if the value of the gift is more than $10,000 per year to any donee. As with any other gifts, you must make the gift at a time when you aren't subject to the claims of any creditors or specific potential creditors and when you are still solvent.

If the annuity or insurance contract is not owned by you, then it usually can't be taken by your creditors. Thus, if your spouse is the beneficiary of your life insurance policy, and is the owner of that policy, if you get sued and lose, the policy cash values aren't lost. Where the proceeds of a policy are payable to your children, you can either make your spouse the policy owner or you might give the contract to your children. If they are minors, your spouse can be the custodian of the contracts or you can have the contracts owned by an insurance trust or partnership, subject to the comments below.

A life insurance contract can be owned by a trust, a partnership or a corporation. (There may be some tax disadvantages when a corporation is the beneficiary of a policy.) A common practice for the management of policies payable to children is to have the contracts owned by an irrevocable life insurance trust. If you own a corporation, the corporation can own the policy and the proceeds can be payable to the corporation or to your spouse. Of course, the contract cash values are then subject to the claims of any creditors of the corporation. And, if you own a controlling interest in the corporation, a creditor could get control of the corporation. Most advisors seem to prefer the use of an irrevocable insurance trust. Some commentators argue that a partnership is a better way to own life insurance. For asset protection purposes, if a limited partnership or an irrevocable trust owns a life insurance policy on your life, it should be very difficult for a creditor to get to the cash values of the policy.

With deferred annuity contracts, the tax benefits are lost if anyone other than a natural person (or a grantor trust) is the owner of the contract. Thus, if you are willing to give up the tax deferral on an annuity contract, you might be able to protect it from future creditors by transferring it to a trust, partnership or even a corporation if the entity can provide asset protection. Generally, that only happens if you don't have full ownership of the entity. However, non natural persons can be the owner of an immediate annuity from which payments begin within a year.

The tax rule regarding deferred annuities does not apply to the ownership of an annuity contract by a grantor trust and certain types of entities that are nominees for the taxpayer. For tax purposes, a grantor trust is treated as if it does not exist. The grantor (also called the settlor or trustor) is subject to income taxes on the income of the trust and to any estate or gift taxes on the transfer of any assets from the trust to someone else. The most common type of grantor trust is a revocable living trust. A foreign trust with a U.S. grantor and one or more U.S. beneficiaries is also a grantor trust. In some cases, an irrevocable domestic trust is a grantor trust because the grantor retains some powers over the disposition of the assets or the income in the trust.

There would be no additional asset protection if the annuity contract were owned by a domestic revocable living trust but an offshore grantor trust isn't necessarily (or usually) a revocable trust. The offshore trust might therefore offer the best asset protection for a deferred annuity contract.  There are no tax problems if a limited partnership owns an annuity in which the payments begin within a year after funding the contract. And, if asset protection is the dominant concern, it might be worth taking a chance on whether the IRS would treat your limited partnership as your nominee for the ownership of a deferred annuity contract.

The states protect certain assets from the claims of creditors but the rules vary greatly from state to state. As a general rule, it seems that life insurance is far better protected in most states than an annuity contract. Twenty three states provide some protection for annuity contracts, as compared with 48 states that offer some protection for insurance policies. In the states that offer protection for life insurance policies, the most common occurs when the policy benefits are payable to a spouse or dependent of the insured.

Therefore, in those states, it should not be necessary to transfer ownership of the insurance contract to a spouse, an irrevocable trust or a partnership. Before resorting to a transfer of ownership, check with a bankruptcy lawyer in your state to find out how much protection is provided by your state's exemptions.

It appears that only nine states offer any substantial exemption protection for annuity contracts, and most of those require that the proceeds be payable to someone other than the contract owner. The implication is that the cash value is protected so long as the proceeds are not payable to the contract owner. This suggests that if you are concerned about protecting a large annuity contract, you might want to make your spouse the beneficiary in those states where this type of exemption is available. In other states, it might be necessary to also make your spouse the owner of the policy if you are concerned about future lawsuits.

In Colorado, 100% of the benefits are protected where the contract provides that the proceeds are left with the insurer, with only income payments being available to the contract owner. Florida, Illinois, Kentucky, Louisiana, Maryland, Massachusetts, New Mexico, Pennsylvania and Rhode Island appear to offer a 100% exemption of life insurance and annuity proceeds payable to beneficiaries other than the insured.

Generally, any annuity contract that is issued as a means of paying a benefit to an employee (or self employed participant) in a tax qualified retirement plan will be protected so long as it's protected under ERISA or so long as the state law exempts non ERISA retirement savings like an IRA or SEP. However, it's not necessary to put any assets into an annuity contract during the accumulation phase of a tax qualified savings plan. The annuity is usually purchased as a means of converting tax deferred retirement funds into a retirement pension.

It seems that life insurance and annuity contracts issued by Swiss insurance companies are not subject to the claims of your creditors so long as your spouse or children are beneficiaries or so long as someone is an irrevocable beneficiary. As I understand it, if you become bankrupt, then the beneficiaries become the owners of the policy and you can't be forced by a U.S. court to liquidate the policy - because you no longer own it. In the case of an irrevocable beneficiary, the Swiss insurance company will not comply with an order by a U.S. court to liquidate the contract. However, there is a six month period during which the transfer of funds to a Swiss insurance or annuity contract can be contested. If you do buy a foreign annuity or insurance contract, you may need to file IRS form 720 and pay a one time 1% excise tax.

While it's important to protect the cash values of an annuity contract from future judgment creditors, it's also important to be sure the funds left with an insurance company aren't subject to the general creditors and other policyholders of an insolvent insurance company.

In that regard, variable annuities offer more protection than fixed annuities because the variable annuity is kept in a "trust fund" separate from the other assets of the insurance company.

The assets underlying a fixed return annuity contract are subject to the claims of all other policyholders of the company. However, pension funds, variable annuity contracts and variable life insurance contracts are segregated from the general funds of an insurance company. They are therefore protected from the claims of other policyholders and from the claims of any other creditors. To be sure that a specific annuity contract is protected this way, you need to ask if it's held in a "separate account". Otherwise, the best protection is to have multiple policies with multiple insurance companies that are all highly rated.

If you find that you don't have the type of contract you prefer to have, you may be able to make a tax free swap of one type of contract for another under tax code section 1035. You can make a tax free swap of an insurance contract for another life insurance contract, for an endowment policy or for an annuity contract. You can swap an endowment contract for another endowment contract or an annuity and you can swap an annuity contract for another annuity.

You can't make a tax free swap of an annuity or endowment policy for a life insurance contract or of an annuity contract for an endowment contract or a life insurance contract. (An endowment is generally a paid up life insurance contract.) So if you want to convert an annuity contract into a life insurance contract for better asset protection, you might have to pay some taxes when you cash in the annuity contract in order to reinvest in a life insurance policy.

You can trade a fixed return annuity for a variable annuity or vice versa. In most cases, the new policy will be treated as a purchase by the issuing insurance company - meaning that commissions and policy issue expenses will be imposed on the purchase. As for the company that you are leaving, they will usually impose any remaining early withdrawal penalties unless your exchange is with another policy issued by them.
 

Further details about protecting your assets from future lawsuits  are available in our subscriber's web site. Changes in the tax laws and various federal and state laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection Strategies.

NOTICE: This Information is intended only for educational purposes and may be regarded as controversial by some legal experts. Readers should consult with a qualified  professional who is familiar with their specific financial and tax circumstances before adopting any ideas that are discussed in this article.

About the author:

Vernon Jacobs is a CPA/CLU who works as a tax author and consultant.