Bankruptcy: Fail to Plan? Plan to Fail

By Andy Ives, CFP®, AIF®
IRA Analyst
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Just as IRA and 401(k) plans have different levels of bankruptcy protection, so too do other possessions. Whether these assets are qualified or not, there are ways to shield oneself from creditors. Case in point – in order to shelter certain monies, a couple in Wisconsin sold their 1974 Plymouth and some real estate. They subsequently purchased a non-qualified annuity with the proceeds. Their creditors did everything in their power to disqualify the annuity to gain access to the funds, but were unsuccessful. The Court ruled that the couple had successfully used “exemption planning” to remove the assets from their bankruptcy estate.

“Exemption planning” is a perfectly legal way to prepare for bankruptcy. It is the practice of organizing one’s financial affairs in order to maximize exemptions (i.e. protect the most amount of property in bankruptcy). Converting nonexempt property into exempt assets can be part of exemption planning. However, if you engage in excessive exemption planning, it can be considered bankruptcy fraud and result in criminal prosecution.

Bankruptcy is governed by federal law. A list of exemptions that debtors can use to exempt property from their estate is outlined in the Bankruptcy Code. These exemptions allow debtors to exclude certain property up to a specific dollar amount in value. Some exemptions are for an unlimited amount, and some have maximum value caps.

A number of states have opted out of the federal exemption list and created their own. Debtors domiciled in the states that opted out are required to use their state’s exemption list. However, 19 states and the District of Columbia currently allow debtors to choose between the federal exemption list or their own state’s list. In the states below, a debtor must select one or the other – they cannot pick and choose from both state and federal exemption amounts.

Alaska, Arkansas, Connecticut, District of Columbia, Hawaii, Kentucky, Massachusetts, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Texas, Vermont, Washington and Wisconsin.

The Wisconsin couple from the court case mentioned above was smart. They elected to claim exemptions under state law to protect their assets. One particular exemption available in Wisconsin is annuity contracts. The ability to exempt an annuity from bankruptcy creditors varies widely from state to state. An annuity that qualifies in one state can fail to be eligible in another. While a few states provide exemptions for virtually all annuities, others do not provide any protection. Also, the timing of the creation of the annuity can affect the availability of the bankruptcy exemption. Some states will only protect annuities purchased more than six months before the bankruptcy case filing.

While bankruptcy can be a difficult situation, it is imperative to make wise decisions about how to handle it. Know what protections are available in your state, and research what the federal government covers. When it comes to bankruptcy – those who fail to plan are simply planning to fail.