Dying with debt is an unfortunate event that happens all too often. However, if you are the beneficiary of a life insurance policy you do not have to pay creditors with the money. Life insurance proceeds pass directly to the beneficiaries as long as the beneficiary information is up-to-date.
Find out how to ensure your life insurance is protected from creditors.
Key Takeaways:
- Life insurance proceeds pass directly to the named beneficiaries
- In most cases, creditors have no rights on life insurance payouts
- It is vital to keep your beneficiary information up-to-date so the death benefit stays out of probate and away from creditors
- There are life insurance products made solely to pay off creditors and ways to use your life insurance to pay off debt while living
Is Your Life Insurance Benefit Safe From Creditors?
In general, your creditors can’t take the death benefit from your life insurance away from your beneficiaries. Insurance regulation prevents life insurance companies from paying out benefits to anyone other than your listed beneficiaries. Therefore, your insurance payout is protected from creditors unless you have co-signed loans or outdated beneficiary listings.
Creditors can access your death benefit if it becomes part of your estate, which can happen if:
- All your beneficiaries die and you don’t update your policy to name new ones
- Your estate is listed as the beneficiary.
Your estate goes through probate court after you die. This is the legal process that decides where your assets go. In probate, lenders and credits can make claims to any assets, including the life insurance proceeds that wind up there. And in probate, lenders have priority over your family and get the money owed before your family.
Avoiding probate is one of the biggest benefits of life insurance for estate planning.
Protecting Your Life Insurance from Creditors
Here are a list of steps you can take to ensure your death benefit goes to your loved ones and not your creditors:
- Updated Beneficiaries: If none of your named beneficiaries is able to receive your death benefit, the money goes to probate. In probate, your creditors have first claim to it. Update your policy’s beneficiaries during major life events and review on a regular basis. Life events are marriage, divorce, and death.
- Use Contingent Beneficiaries: Using a 2nd-tier of beneficiaries who can accept the money will help keep you proceeds out of probate.
- Do not list your estate as a beneficiary: As soon as your estate has possession of the money, it is subject to probate. If you name your estate as a beneficiary you lose the instant transfer of ownership and creditors can tie the money up in legal proceedings.
- Provide specifics for beneficiaries: When naming beneficiaries you can use names, relationship terms (ie-current spouse) or both. The more specific you are the easier it is for the insurance company to confirm and pay out your benefit.
What debts are not collectible after your death?
Most debt can be collected from the assets in your estate after you die. Creditors can collect on private loans and any debt from a shared account or you co-signed on.
However, federal student loans and some private student loans are forgiven upon your death.
Can creditors collect from your family?
Even though life insurance prevents creditors from receiving any of the death benefit, there may still be some responsibility for your family to pay back debts.
This is why it is extremely important to calculate how much life insurance coverage you need and include debt in that calculation. Our preferred method of calculating your life insurance needs is the DEEM methodTM.
The DEEM methodTM stands for Debt, Expenses, Education, and Mortgage. You add up all your outstanding debts, any education costs you want to cover for your children, your outstanding mortgage, and a multiple of your annual living expenses and use that for your life insurance coverage.
And your life insurance needs change over time as your debt and expenses change, so you need to periodically review your coverage to ensure you are adequately protected.
If you are married and in a community property state you need to be extra careful as your spouse is responsible for any debts taken on during marriage. There are currently 9 community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington.
Additionally, there are 30 states that hold you responsible for your parents debt, called filial responsibility laws. These rules are state specific so work with a financial advisor if you are concerned about you or your parents debts. (Read more about filial responsibility laws here).
Are you able to use life insurance to pay off creditors?
Generally, life insurance is meant to cover living expenses of your dependents after you die. However, there are ways to use your life insurance policy to pay off creditors while you are alive. The downside is that this lowers the benefits paid to your beneficiaries.
The main ways to use get liquidity from your life insurance to pay off creditors are:
- Policy Loans: Some permanent life insurance products allow you to take a loan against your policy. Your life insurance is collateral and you get money to pay off debt. However, any outstanding loan amount is taken from the death benefit paid out when you die.
- Viatical settlement: This is when you sell your life insurance policy for cash. The payoff you receive will be significantly less than the total coverage amount and your beneficiaries will receive no money.
- Collateral assignment: Some creditors will allow you to use life insurance as collateral for a loan. If you don’t pay back the loan before you die, the creditor recoups its money from your life insurance benefit before it goes to your beneficiaries.
- Credit life insurance: This is a type of decreasing term life coverage that covers a specific loan. The main example is mortgage protection insurance where the life insurance payoff amount goes to your creditor directly. There is no benefit for your family so you will need additional coverage.
- Cash surrender: Permanent life insurance has a cash value account. You have the option to surrender your policy and take the amount in the cash value account, net any surrender charges in your contract. When you surrender your policy, your family no longer has coverage.
- Partial withdrawals: Similarly, most permanent life insurance has the option for limited free partial withdrawals. This allows you to withdraw some of your cash value every year. However, withdrawing money from your cash value results in paying higher future charges and can put your policy at risk of lapsing due to being underfunded.
It is important to know the purpose of your life insurance and the features and options your policy has. Knowing how your life insurance benefit is paid out will help you to optimize the financial protection of your loved ones.
The Final Word:
You purchased your life insurance for a reason, not for it to be taken by creditors. Make sure you are updating your beneficiary information and you are keeping any life insurance payouts out of your estate.
One of the biggest benefits of life insurance is it avoids probate and is protected from creditors.
Frequently Asked Questions (FAQs):
In most cases, you aren’t responsible for your parent’s debt. The creditor can make a claim against your parent’s estate. As long as you are the named beneficiary on a life insurance policy you don’t owe creditors any of the payout.
Just because you aren’t responsible for a family member’s debt doesn’t mean you won’t get contacted by debt collectors. They may try to coerce you into paying debt you don’t need to. Offer to provide the debt collector with a death certificate and if they continue to harrass you, you can safely ignore them. Additionally, you can file a claim with the Federal Trade Commission (FTC), Consumer Financial Protection Bureau (CFPB), or even your stat consumer protection agency.
You’re in luck, life insurance passes directly to your named beneficiary upon your death. By avoiding probate, life insurance proceeds are shielded from creditors. You can also set up a trust and name the trust the beneficiary of your life insurance policy to keep it away from creditors.
The beneficiary of a life insurance policy is the owner of the money after the insured’s death. You are not responsible to pay debts of others unless you co-signed on the debt or in a state that has community property or filial responsibility laws.