In estate planning be aware of fraudulent transfer laws

A primary goal of your estate plan is to transfer wealth to your family according to your wishes and at the lowest possible tax cost. However, if you have creditors, be aware of fraudulent transfer laws. In a nutshell, if your creditors challenge your gifts, trusts or other strategies as fraudulent transfers, they can quickly undo your estate plan.

2 fraud types

Most states have adopted the Uniform Fraudulent Transfer Act (UFTA). The act allows creditors to challenge transfers involving two types of fraud that you should be mindful of as you weigh your estate planning options:

  1. Actual fraud. This means making a transfer or incurring an obligation “with actual intent to hinder, delay or defraud any creditor,” including current creditors and probable future creditors.

Just because you weren’t purposefully trying to defraud creditors doesn’t mean you’re safe from an actual fraud challenge. Because a court can’t read your mind, it will consider the surrounding facts and circumstances to determine whether a transfer involves fraudulent intent. So before you make gifts or place assets in a trust, consider how a court might view the transfer.

  1. Constructive fraud. This is a more significant risk for most people because it doesn’t involve intent to defraud. Under UFTA, a transfer or obligation is constructively fraudulent if you made it without receiving a reasonably equivalent value in exchange for the transfer or obligation and you either were insolvent at the time or became insolvent as a result of the transfer or obligation.

“Insolvent” means that the sum of your debts is greater than all of your assets, at a fair valuation. You’re presumed to be insolvent if you’re not paying your debts as they become due.

Generally, the constructive fraud rules protect only present creditors — that is, creditors whose claims arose before the transfer was made or the obligation was incurred.

Know your net worth

By definition, when you make a gift — either outright or in trust — you don’t receive reasonably equivalent value in exchange. So if you’re insolvent at the time, or the gift renders you insolvent, you’ve made a constructively fraudulent transfer, which means a creditor could potentially undo the transfer.

To avoid this risk, analyze your net worth before making substantial gifts. Even if you’re not having trouble paying your debts, it’s possible to meet the technical definition of insolvency.

Fraudulent transfer laws vary from state to state, so consult an attorney about the law in your specific state.

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Are your retirement savings secure from creditors?

A primary goal of estate planning is asset protection. After all, no matter how well your estate plan is designed, it won’t do much good if you wind up with no wealth to share with your family.

If you have significant assets in employer-sponsored retirement plans or IRAs, it’s important to understand the extent to which those assets are protected against creditors’ claims and, if possible, to take steps to strengthen that protection.

Employer plans

Most qualified plans — such as pension, profit-sharing and 401(k) plans — are protected against creditors’ claims, both in and out of bankruptcy, by the Employee Retirement Income Security Act (ERISA). This protection also extends to 403(b) and 457 plans.

IRA-based employer plans — such as Simplified Employee Pension (SEP) plans and Savings Incentive Match Plans for Employees (SIMPLE) IRAs — are also protected in bankruptcy. But there’s some uncertainty over whether they’re protected outside of bankruptcy.

IRAs

The level of asset protection available for IRAs depends in part on whether the owner is involved in bankruptcy proceedings. In a bankruptcy context, creditor protection is governed by federal law. Under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), both traditional and Roth IRAs are exempt from creditors’ claims up to an inflation-adjusted $1 million.

The IRA limit doesn’t, however, apply to amounts rolled over from a qualified plan or a 403(b) or 457 plan — or to any earnings on those amounts. Suppose, for example, that you have $4 million invested in a 401(k) plan. If you roll it over into an IRA, the entire $4 million, plus all future earnings, will generally continue to be exempt from creditors’ claims in bankruptcy.

To ensure that rollover amounts are fully protected, keep those funds in separate IRAs rather than commingling them with any contributory IRAs you might own. Also, make sure the rollover is fully documented and the word “rollover” is part of its name. Bear in mind, too, that once a distribution is made from the IRA, it’s no longer protected.

Outside bankruptcy, the protection afforded an IRA depends on state law.

What about inherited IRAs?

In 2014, the U.S. Supreme Court held that inherited IRAs do not qualify as retirement accounts under bankruptcy law. The Court reasoned that money in an IRA retirement account was set aside “at some prior date by an entirely different person.” But after an inheritance, it no longer bears the legal characteristics of retirement funds because the heir can withdraw funds at any time without a tax penalty and take other steps not required with non-inherited IRAs. Therefore, they’re not protected in bankruptcy. (Clark v. Rameker)

Consult with your attorney about protection for retirement accounts in a nonbankruptcy context.

Protect yourself

If you’re concerned that your retirement savings are vulnerable to creditors’ claims, please contact us. The effectiveness of these strategies depends on factors such as whether future creditor claims arise in bankruptcy and what state law applies.

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