Lawsuit Protection Part II: Assets That Protect Themselves

ERISA - Exempt Asset Protection
ERISA plans (e.g. 401(k)) have built-in asset protection.

In Lawsuit Protection Part I, I discussed the advantages of being judgment proof. To reiterate, the main purpose is to discourage aggressive attorneys, because there is no financial upside for them.  That article can be summed up as follows: Judgment proof people have nothing to lose, so would-be suing attorneys have nothing to gain.  Being judgment proof is a very effective way to keep a lawsuit from ever being filed against you.

Built-In Asset & Lawsuit Protection

But there is an obvious downside to being judgment proof: We all want to have wealth and assets. How can one have significant wealth AND be judgment proof at the same time? Before we tackle that concept in Lawsuit Protection Part III, it’s important to discuss how different assets are treated in the eyes of law. Assets are not created equal when it comes to wealth protection laws.

What Is An Asset?

Accountants will tell you that assets minus liabilities equals equity, or (A – L = E).  In the realm of asset protection, we think about protecting equity. That’s the real asset. A building valued at $6oo,000 with a $625,000 mortgage in place is not an asset.  It’s a liability.  That building actually represents a debt. It’s underwater and doesn’t need to be protected. Liquid assets like cash, stocks, bonds, and physical precious metals are pure equity and in need of protection most of the time (unless they’ve been purchased on margin or with debt).

Let’s consider the example of a 33 year old physician living in California. Assume this physician has $90,000 of cash in the bank and a home valued at $400,000 (with a $250,000 mortgage). Further assume that she owes $200,000 in student loans. In a strict balance sheet accounting sense, this person is in the red (i.e. she has negative overall equity), but she does have assets.

Is she judgment proof (assuming there is no malpractice insurance)?  To answer this question, we must first understand the difference between exempt assets and non-exempt assets. In general, exempt assets are off limits. They can’t be reached by creditors. Non-exempt assets are everything else.

Exempt and Non-Exempt Assets

Some types of assets are exempt from lawsuit judgments and other creditor claims. Those assets cannot be touched. Some exempt assets include qualified retirement plans under the Employee Retirement Income Security Act (ERISA) and homesteaded property. In some states like Florida and Texas, equity in your home is completely protected by homestead laws.

In almost all scenarios, cash in the bank  is not protected at all. It is a non-exempt asset. That means a court can order that cash in the bank be used to pay off a verdict. An asset protection attorney could help convert cash into an exempt asset category. One simple way to do that would be to simply pay down the mortgage on a homestead property.

Converting Property from Non-Exempt to Exempt

Why pay down the mortgage as opposed to the student loans? Well, as discussed above, homesteaded property is an exempt asset. There are laws in place that automatically place homesteads beyond the reach of creditors. By paying down a mortgage, your can protect the asset AND keep it available for future use (i.e. a home equity line can be tapped in the future). Just as important, if tragedy strikes and for some reason other creditors come calling, the $60,000 would be safely exempt from the claims of those creditors, including student loan lenders! That’s more relief than one could get even in bankruptcy court. Exempt assets are protected assets!

Again, the key to fortifying your assets is being judgment proof, even if you have significant wealth. Take practical steps today to understand the types of assets you have, and then begin figuring out how to protect them one at a time as part of an overall asset protection strategy.