What Is Asset Protection?

Asset protection is the adoption of strategies to guard one’s wealth. Asset protection is a component of financial planning intended to protect one’s assets from creditor claims. Individuals and business entities use asset protection techniques to limit creditors’ access to certain valuable assets while operating within the bounds of debtor-creditor law.

Understanding Asset Protection

Asset protection helps insulate assets in a legal manner without engaging in the illegal practices of concealment (hiding of the assets), contempt, fraudulent transfer (as defined in the 1984 Uniform Fraudulent Transfer Act), tax evasion, or bankruptcy fraud.

Experts advise that effective asset protection begins before a claim or liability occurs since it is usually too late to initiate any worthwhile protection after the fact. Some common methods for asset protection include asset protection trusts, accounts-receivable financing, and family limited partnerships (FLP).

If a debtor has few assets, bankruptcy may be considered the more favorable route compared to establishing a plan for asset protection. If significant assets are involved, however, proactive asset protection is typically advised.

Certain assets, such as retirement plans, are exempt from creditors under United States federal bankruptcy and ERISA (the Employee Retirement Income Security Act of 1974) laws. In addition, many states allow exemptions for a specified amount of home equity in a primary residence (homestead) and other personal property such as clothing.

Asset Protection and Real Estate

Jointly-held property under the coverage of tenants by entirety can work as a form of asset protection. Married couples who hold mutual interest in property under tenants by entirety share a claim to a whole piece of property and not subdivisions of it.

The combined ownership of the property means that creditors who have liens and other claims against one spouse cannot attach the property for their debt reclamation efforts. If a creditor has claims against both spouses, the tenants by entirety stipulations would not protect the asset from being pursued by that creditor.

Some attempts at asset protection include putting the property or financial resource in the name of a family member or other trusted associate. For example, an heir might be gifted ownership of real estate or other property while the actual owner continues to reside in the property or make use of it. This could complicate efforts to seize property as actual ownership must be determined. Financial accounts may also be domiciled in offshore banks in order to legally avoid paying taxes against those funds.

What Is Annualized Income?

Annualized income is an estimate of the sum of money that an individual or a business generates over a year’s time. Annualized income is calculated with less than one year’s worth of data, so it is only an approximation of total income for the year. Annualized income figures can be helpful for creating budgets and making estimated income tax payments.

Understanding Annualized Income

Annualized income can be calculated by multiplying the earned income figure by the ratio of the number of months in a year divided by the number of months for which income data is available. If, for example, a consultant earned $10,000 in January, $12,000 in February, $9,000 in March and $13,000 in April, the earned income figure for those four months totals $44,000. To annualize the consultant’s income, multiply $44,000 by 12/4 to equal $132,000.

How Estimated Tax Payments Work

Taxpayers pay annual tax liabilities through tax withholdings and by making estimated tax payments each quarter. There are many sources of income that are not subject to tax withholding. Income from self-employment, interest and dividend income and capital gains are not subject to tax withholdings, along with alimony and some other sources of income that may be reported to a taxpayer on Form 1099. To avoid a penalty for tax underpayment, the total tax withholdings and estimated tax payments must equal to the lesser of 90% of the tax owed for the current year or the full tax owed the previous year.

Examples of Annualized Income That Fluctuates

Computing estimated tax payments is difficult if the taxpayer’s income sources fluctuate during the year. Many self-employed people generate income that varies greatly from one month to the next. Assume, for example, that a self-employed salesperson earns $25,000 during the first quarter and $50,000 in the second quarter of the year. The higher income in the second quarter indicates a higher total level of income for the year, and the first quarter’s estimated tax payment is based on a lower level of income. As a result, the salesperson may be assessed an underpayment penalty for the first quarter.

Factoring in the Annualized Income Installment Method

To avoid the underpayment penalties due to fluctuating income, the IRS Form 2210 allows the taxpayer to annualize income for a particular quarter and compute the estimated tax payments based on that amount. Schedule AI of Form 2210 provides a column for each quarterly period, and the taxpayer annualizes the income for that period and computes an estimated tax payment based on that estimate. Using the salesperson example, Form 2210 allows the taxpayer to annualize the $25,000 first quarter income separately from the $50,000 second quarter income.

What Are the Actual Deferral Percentage (ADP) & Actual Contribution Percentage (ACP) Tests?

The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are two tests that companies must conduct to ensure that their 401(k) plans don’t unfairly benefit highly-paid employees at the expense of others.

Companies that offer 401(k) plans must conduct the tests in order to retain the qualified status of their plans under IRS rules and the Employee Retirement Income Security Act (ERISA).

If the plan fails either test, the employer must take corrective action in the 12-month period following the close of the plan year in which the oversight occurred. Failure to do so can result in the IRS imposing pecuniary penalty fees, plan disqualification, and fiduciary liability on the part of the employer. 

How ADP and ACP Tests Work

The ADP test compares the average salary deferral percentages of highly compensated employees (HCE) to that of non-highly compensated employees (NHCE). An HCE is any employee who owns more than 5% interest in the company at any time during the current or previous plan year or earned more than $130,000 during the 2020 tax year. 

The ADP test takes into account both pre-tax deferrals and after-tax Roth deferrals, but no catch-up contributions, which may be made only by employees age 50 and over. To pass the test, the ADP of the HCE may not exceed the ADP of the NHCE by more than two percentage points. In addition, the combined contributions of all HCEs may not be more than two times the percentage of NHCE contributions.

The ACP test uses a similar method as the ADP test except that it uses matching contributions or employee after-tax contributions.

Correcting an ADP/ACP Test Failure

When employers fail the ADP/ACP tests, they can remedy the failure by refunding excess contributions back to HCEs in the amount necessary to pass the test. However, these refunds will be liable for income tax for the HCE individuals. 

Some companies set buffer zones within their plan documents to steer plans away from potentially failing the ADP/ACP test in the first place. One option is setting a cap on contributions by HCEs. Another option is to place a contribution limit on HCEs at the point where the plan would fail an ADP/ACP test. Setting plan buffer zones may require employers to conduct ADP/ACP test projections, typically in the middle of the plan year, to determine if any restrictions need to be applied. 

Still, some companies use a Safe Harbor 401(k) plan to avoid the ADP/ACP test entirely.

What Is a Safe Harbor Plan? 

Safe Harbor 401(k) plans allow sponsors to bypass ADP/ACP and other non-discrimination testing in exchange for providing eligible matching or nonelective contributions on behalf of their employees.

To qualify for Safe Harbor, a company must provide a basic match, such as a 100% match on the first 3% of deferred compensation and a 50% match on deferrals of 3% to 5%. They may also provide each employee with a nonelective contribution of at least 3% of compensation, regardless of how much the employee contributes or if they contribute at all.

What Is the American Opportunity Tax Credit (AOTC)?

The American Opportunity Tax Credit (AOTC) is a tax credit for qualified education expenses associated with the first four years of a student’s postsecondary education. The maximum annual credit is $2,500 per eligible student. The student, someone claiming the student as a dependent, or a spouse making postsecondary education payments can claim the AOTC on their tax return.

Understanding the American Opportunity Tax Credit (AOTC)

With the AOTC, a household with a qualifying student can receive a maximum $2,500 tax credit per year for the first four years of higher education. Parents claiming a dependent child who is a full-time student ages 19 to 24 can claim an additional $500 Child Tax Credit.

The AOTC helps with educational costs such as tuition and other expenses related to a student’s coursework. Eligible students (or their parents) can claim 100% of the first $2,000 spent on school expenses and 25% of the next $2,000. This comes out to a maximum credit of $2,500: (100% × $2,000) + (25% × $2,000).

In general, tax credits are refundable, nonrefundable, or partially refundable. Up to $1,000 (40%) of the AOTC is refundable, making it a partially refundable tax credit. So, if the credit brings your tax liability to $0, you can receive 40% of your eligible credit (up to $1,000) as a refund.

AOTC Eligibility Requirements

Like other tax credits, you must meet specific eligibility requirements to claim the AOTC.

Who Can Claim the AOTC?

To claim the AOTC on your tax return, you must meet all three of these requirements:

• You pay qualified education expenses for higher education.
• You pay the education expenses for an eligible student.
• The eligible student is either you, your spouse, or a dependent whom you claim on your tax return.

Additionally, you must receive Internal Revenue Service (IRS) Form 1098-T to claim the credit. Here’s an example of a completed form:

Source: Internal Revenue Service

Which Students Qualify for the AOTC?

A student is eligible for the AOTC only if they meet certain requirements. Specifically, the student must:

• Be taking courses toward a degree or some other recognized education qualification
• Be enrolled at least part time for at least one academic period beginning in the tax year
• Not have finished the first four years of higher education at the beginning of the tax year
• Not have claimed the AOTC (or the former Hope credit) for more than four tax years
• Not have a felony drug conviction at the end of the tax year

Which Expenses Qualify for the AOTC?

For the purposes of the AOTC, qualified education expenses include tuition and some related costs required for attending an eligible educational institution. An eligible educational institution is any accredited public, nonprofit, or private college, university, vocational school, or other postsecondary educational institution. Related expenses include:

• Student activity fees paid to the school as a condition of enrollment or attendance
• Books, supplies, and equipment needed for classes, whether or not you buy them from the school

You can pay for qualified education expenses with student loans. However, you can’t claim the credit if you paid for expenses with scholarships, grants, employer-provided assistance, or funds from a 529 savings plan.

What Are the Income Limits for the AOTC?

To claim the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 if married filing jointly). The credit begins to phase out above these limits and disappears entirely if your MAGI is above $90,000 ($180,000 for married filing jointly).