Cash Value Life Insurance provides an array of various benefits and one unique benefit it brings to the table (for some people) is the fact that cash values are often protected from creditor and liability claim. So unlike the money in your bank account or general brokerage account, the cash values in a life insurance policy can often be concealed from individuals who sue you either in an attempt to force you to indemnify them from a loss they claim is your fault or those who claim that you owe them money under contract and have failed to pay.
Additionally, if you take money out of a life insurance policy and spend it (e.g. using it for income) this method of accessing money doesn’t create taxable income and is therefore typically untraceable to those making a claim against you.
But, we do want to be very clear about this benefit as it’s often overstated and certainly not bullet proof. For some people, it’s not even available so care needs to be taken when approaching life insurance from this angle.
Each State is Different
Creditor and liability protection for life insurance is primarily a state law consideration, meaning the exact protections you have will vary depending on the state in which you live (and potentially making it even more complicated sometimes dependent on the state in which your life insurance contract was issued).
Some states are simply more generous regarding this benefit than others. Here’s a handy guide to use to determine where the best protections exist.
And if you look at that guide, you’ll pretty quickly notice just how, much this benefits varies from state to state. Some states like New York, Florida, and Vermont (as well as others) are extremely generous in protecting 100% of the cash surrender values of a policy. Others like California, Georgia, and Virginia offer little if any protection. It’s also worth noting that some states offer this benefit dependent on appropriate beneficiary selection (e.g. beneficiary must be yourself, wife, or kids).
What about Bankruptcy?
Since federal law governs bankruptcy, there’s a different set of rules that apply and they aren’t nearly as generous. Cash values are only protected up to slightly less than $11,000 in the case of bankruptcy.
What about the IRS?
When you owe the US Treasury money their collection agent, the Internal Revenue Service, isn’t bound by the rules that hold other collection services up. If you have an unpaid tax liability hanging over your head, life insurance isn’t going to work as your secret hiding place when you try to convince the IRS that you simply don’t have the money.
So what exactly is it good for?
It’s good for individual disputes regarding monetary responsibilities you may or may not have to someone else. The protection itself is useful when someone sues you and wins judgment against you. It won’t completely dodge the judgment that you may owe, but it does act as a way to prevent immediate liquidation of assets and force the plaintiff to accept a payment overtime.
It’s not the only option
To be fair we must note that while this is protection is unique it’s not exclusive. There are other means to this end, but again those means vary by state and none of them are as simple as life insurance. For example, many states offer IRA protections are very similar. But IRA’s are simply accounts, within which you must choose an asset, or assets. Additionally IRA distributions are generally not protected in the same fashion life insurance distributions.
A note on Surrender Charges
This topic is an area where surrender charges might actually be helpful. Keep in mind that even in states where protections are somewhat weak, the access one might have is only to the cash surrender value of a policy. This makes perfect sense since the insurance company will always keep cash values that would not be paid to the contract owner due to surrender charges.
But the cash that is encumbered by surrender charges is still cash in the policy, and it still receives the same interest credited to it that any cash surrender value would. So designing a policy to make much of the incoming money subject to surrender charges could work to lay some additional protections.
A Note on Death Benefits
Death benefit proceeds are generally always protected from creditor or liability claim and the main reason for this is that life insurance proceeds typically bypass the probate process (i.e. broadly speaking the deceased’s liabilities can only be addressed with his or her estate and since the monies paid out by a life insurance contract don’t go there, they aren’t considered.
Do keep in mind that none of what we offer here should be construed as legal advice and you should always seek out the advice of a qualified professional (generally an attorney) before acting on anything like the above information. If you hurt yourself trying to self-implement anything we’ve discussed here or elsewhere about cash value life insurance and liability protection, we’re sorry for your troubles but we warned you.