What is the best way to avoid bankruptcy?

I was first asked the above question shortly after I first opened my firm. The answer is that bankruptcy is simply a financial tool. Metaphorically, you don’t avoid a tool you put it away inthe toolbox for when you need it. The use of this tool is not unlike the use of a screw driver. We all have had the situation where we either needed to drive a screw or to remove a previously set screw. The answer may be that you need the tool specifically designed for the purpose at hand. If you try using another tool such as a hammer you will not get the job done right and will cause a lot of damage. But to answer the central question- to avoid the need for a bankruptcy- you need to avoid the critical financial distress that can only be removed by a bankruptcy petition.

For individuals this means avoiding or reducing that risk that comes with our day to day financial transactions. The circumstances that most often give rise to a bankruptcy filing are:

1. Illness and the cost of medical care.

2. Divorce and other family disruptions such as the death of a spouse.

3. Disability, job loss and a general loss of income.

4. Excessive debt.

Although most people see the last factor as the principal cause of bankruptcy, it is actually the least common cause and almost never the initial or primary cause. Usually disability, family problems or illness preceded an increase in debt. Bankruptcy is effective in relieving debt. A bankruptcy will not bring back your spouse, give you good health or help you regain a lost job, but it will remove the debt that follows life’s misfortunes. This explains the significant rise in bankruptcies in recent years. In today’s economy even in distressed economic conditions individuals can cover expenses by borrowing. Even a brief job loss or a minor family problem can lead to an unmanageable debt load that will continue to be rolled over until some personal good fortune occurs or a bankruptcy petition is filed. If the average unsecured debt (such as credit card) is $10,000 and the average income is just $44,000 then the average person is perpetually at risk.

The experts on television and radio all say "save" as a first line of defense or "pay down your unsecured debt". If you are saving, they recommend retirement accounts because of the tax advantage. It is very difficult to convince people that this common sense approach is completely wrong. You have to prepare for the eventuality, not just react to it. Get away before the hurricane hits. A flash light when the storm arrives is useful but will probably not save your life. So before you save, strengthen your insurance coverage. It is important to remember that health, disability and life insurance, in this order, are the most vital to have. Most people get this from their employer which is inexpensive but has a hidden trap. If you lose your job you lose your coverage because the policy belongs to the employer and not to you. This does not have to be the case.

You can buy life and disability policies that have a guarantee of insurability. That means that at any time when the original policy is in force you can increase the coverage. For example, if Mr. Smith has a personal $10,000 life policy with a guarantee of insurability to $100,000 and is covered by an extended benefit life policy from his employer to say $50,000 if he loses the employers policy when he changes jobs he can simply expend his own coverage. Disability insurance works very much the same way- all you need is a guarantee of insurability with the policy when you purchase. In America, health insurance can be a problem if you are unemployed. You may find you cannot get coverage even if you are healthy because of the fact that issuers understand the total risk for employed individuals are less than the total risk for the unemployed or self employed. So what you need to do is review all the plans through your employer or on your own. Remember, what looks cheap may not be in the long run and don’t be fooled by the "benefit" statement. The policy that seems to offer the least benefits may in fact have the broader coverage. For example, a policy that is part of a group with limited benefits may let you convert to individual coverage at a low cost compared to a high benefit plan. In other words see what it takes to keep the policy in effect if you change or lose your employment. Until our Congress stops taking bribes from the insurance lobby health problems there will continue to be greater bankruptcy filings.

Saving for a rainy day

IRA’s and 401k’s are good long term investments but they are not a way to save for an emergency. When you borrow from a retirement plan you must either pay it back timely or incur a tax penalty.

“But I get a tax break when I put the money in and my employer pays part of the contribution.”

Not exactly correct. The employer’s share is only yours if you are vested, which can take seven years or even ten years. The tax itself is only deferred when you remove the money if you wait until the retirement age of 59.5 years, here there is no-penalty, but if you need the money sooner you will pay a penalty of 10%. The real trap here is borrowing against the retirement plan. What happens when you lose your job and owe money on the loan? If you default you owe taxes and a penalty and have no job. The nice blonde lady who gives you advice on TV has most of her own money in annuities. Why? She is cautious and knows that the long term tax advantages of annuities are no worse then an IRA and if for some reason she needs some or all the money now- there is no penalty!My own preference is life insurance plus an IRA. Here you have: term insurance to cover the risk of premature death, whole life as savings and an IRA for retirement income. If you have limited funds, you can find some policies that do all three. This advise is not meant to go against your employer's 401K, however my recommendation is to not put all your savings here.

How much is enough?

The dark-haired lady who gives the advice on the morning news show says that you should have six months of income set aside for emergencies-  like losing your job. For instance, Bob and Carol Jones are a couple with two children and an $80,000 a year income. If they follow the dark-haired lady’s advice, they will have $40,000 in a savings account earning no more then 2% interest. Why is this advice wrong? Well first you do not need six months income you need six months’ expenses. So if Bob and Carol are like most of us and live pay check to pay check they would need six months net pay or about 70% of their gross or $28,000. But this is just a number and one with little real world application.

Bob and Carol actually need a plan for what will happen in a personal financial crisis. lets say they already have a plan for a house fire. Perhaps the couple’s son brought information home from school about having an emergency plan in case of a house fire. This of course is excellent advice and I highly recommend it. However-  you are far more likely to lose a job, get divorced or become seriously disabled. But most likely have no plan for any of these eventualities. So before you put a dollar in the bank have an emergency "budget" plan. Making this "budget" plan permits you to maintain your current life style on as little cash as possible. It can also mean having your resume printed and ready and maintaining a good working relationship with your spouse. This may also lead to buying the smaller house or car, and even more significantly making sure you have your current debts well under control.

My last piece of advice is if you are married or living with someone, pay the bills together. One of the saddest things I have seen as a bankruptcy attorney is the pain caused by the partners in a loving relationship who cannot communicate their financial problems to each other. Two people working together can always do more than one alone.  For more information call me toll free at 888-914-3328 or contact our bankruptcy law firm online.