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How personal bankruptcy affects your life insurance and annuities
Whether you are facing bankruptcy or considering it, one of the biggest questions you may have is how your lifestyle and property will be affected.
You may be able to keep your house after a bankruptcy, and you'll be able to retain a specified amount of the cash value that has accumulated within any permanent life insurance policies you own.
Although bankruptcy courts consider cash value within life insurance an asset, "federal law permits a person declaring bankruptcy to 'exempt' certain types of property from creditors to make a fresh start," says Weldon "Reed" Allmand, a bankruptcy lawyer in Texas.
States where you can choose federal bankruptcy exemptions
Under federal exemptions, you can protect up $10,775 of a life insurance policy's cash value. Also, married couples may double all exemptions under the federal bankruptcy code. Federal bankruptcy law specifically allows each state to "opt out" of federal exemptions and set their own guidelines pertaining to assets you can protect from creditors in a bankruptcy. Many states have chosen to opt out and others allow you to choose between state or federal exemptions. No state is solely under federal exemptions.
You cannot take both federal and state exemptions; when filing for bankruptcy you have to choose one or the other. Furthermore, if you don't need to use the real estate exemption to protect your home, or don't need to use the full exemption amount, you can apply up to $11,500 to protect any other assets from creditors, such as your life insurance cash value.
"Typically, life insurance and annuities are treated differently than other assets because of the nature of the proceeds, and the cash value is paramount to providing protection to the family," says Cliff F. Wilson, President of the National Association of Insurance and Financial Advisors (NAIFA). The courts want the policy to continue to provide life insurance protection. Wilson notes that some states require you to have had the policy for one to two years in order for it to be protected under a state exemption.
Other benefits for your dependents (including disability benefits, unemployment benefits and health insurance) are also exempt from seizure.
Even if you are eligible for a federal exemption in your state, remember that the state decides what is upheld in bankruptcy court within their jurisdiction.
"You'll find that most states have passed laws that follow the federal guidelines but have specific differences," says Allmand. "If you cash in an insurance policy before you file for bankruptcy, the proceeds may not be exempt from seizure under law."
For example, Nevada will exempt a life insurance policy or proceeds if the annual premiums are not over $1,000. Nevada also lets you protect annuity payments up to $350 a month.
In Florida, the cash value of a life insurance policy may be exempt, but only up to the value of a policy owned by the debtor to insure his own life. If a debtor purchases life insurance on the life of another person, such as his spouse, the cash value of that policy is not exempt under Florida law. Even so, Florida law protects all of the cash surrender value of life insurance policies and annuity proceeds from action by creditors, without limitations, for the beneficiary of the policy.
Insurance benefits for a debtor in Texas who is the beneficiary of the insurance policy are exempt with an unlimited dollar amount. This extends not only to life insurance but also to health, accident, mutual and fraternal insurance policies, as well as annuities or benefits provided by an employer.
To determine what exemptions you may qualify for, Allmand recommends consulting an attorney familiar with bankruptcy rules in your state. He also advises that you disclose all your life insurance policies to your attorney.
"They should fully disclose all the different types of coverage they have to their attorney, so the attorney can give them accurate advice and a game plan on how to protect those assets," he suggests.
Money held in annuities that are part of employer-sponsored retirement plans — including 401(k) plans, defined benefit plans and some types of 403(b) tax sheltered annuity plans — is protected from creditors by ERISA, according to the Association for Insured Retirement Solutions, a trade organization for the annuity and variable-products industry.
According to the U.S. Department of Labor, this protection is available in the event of bankruptcy and for judgments under state creditor-protection laws and, unlike property exemptions, state laws cannot supersede these protections. Keep in mind that not all retirement plans are ERISA plans, so check with your employer to know if yours qualifies. In most cases, if your employer is contributing to your retirement account, you will probably be protected under ERISA. Many states have chosen to supplement ERISA by enacting state laws that extend protection to other types of retirement accounts and annuities.
Individual annuities that you take out on your own do not share the same protections as an employer-sponsored annuity. According to Allmand, the exemptions of individual annuities vary from state to state.
A few states, such as Florida, New York and Texas, protect any annuity owned by a resident of the state from creditors, but the total amount of money you can protect also varies from state to state, so be sure you know exactly what protections your state offers for your annuity assets.
"Insurance was not intended to move money from one account to another. It was designed to protect families when something unexpected happens," Wilson says. "This is why the states have always worked to protect such assets."