Can Life Insurance Proceeds Be Taken By Creditors?
Written By Cameron McDowell
Dec 14, 2021
7 mins read
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Securing Your Loved Ones: Can Life Insurance Proceeds Be Taken By Creditors?
Passing away with unpaid debt can result in the loss of life insurance policy proceeds, which can be financially and emotionally devastating to your beneficiaries.
Read on to find out the answers to some of the most common questions about life insurance proceeds and debt. Specifically, if creditors can take your proceeds, when your family members are obligated to pay your debts, and how to protect your death benefit even after you die.
Life Insurance Proceeds And Debt
13% of all Americans expect to pass away with unpaid debts, and it’s no mystery why this happens. Between credit card debt, mortgages, student loans, and monthly auto payments, it can feel like debt is inevitable. But how is the state of your debts relevant to your life policy? The answer is that unpaid loans don’t disappear when you’ve passed away.
In most states, creditors can pull from your estate – your total net worth at the time of your death – to pay off any unpaid debts. If your life plan is part of your estate, your beneficiaries may lose out on their payout altogether.
Can Creditors Take My Life Insurance Death Benefit?
Protection is essential, so you may be worried about creditors taking your beneficiaries’ benefits after you pass away. Luckily, state exemption laws protect your life insurance proceeds from being taken by creditors – most of the time.
Generally speaking, creditors cannot access your life insurance benefits without permission from the policy owner. Only your beneficiaries will be able to make claims on your assets, and your life insurance company won’t pay out to any creditor unless explicitly instructed to do so.
However, creditors do have access to your probate estate and all its associated property, assets, and liabilities in other states. This happens because some types of debt are considered part of your estate. Therefore, your property and estate are susceptible to being seized by lenders. But what does this have to do with your life insurance, provided that state exemptions generally protect insurance policies?
If you name your estate as the beneficiary on your life insurance policy, it becomes part of the probate process. That means it can be used to pay creditors for the remaining amount of debt. Therefore, despite state laws, creditors may take death benefits directly from your insurance agency in some cases.
Once the debt has been settled through life insurance proceeds and any other estate assets, the remaining amount will be paid out to the named beneficiaries. Additionally, creditors may also be entitled to your death benefits if your beneficiaries pass away before you do.
In What Cases Will My Family Have To Pay For My Debt?
Given that state law usually protects life insurance policies from being directly accessed by creditors, beneficiaries are often not required to use the proceeds to pay off debts. However, most debts with private creditors are passed on to the deceased person’s living relatives or spouse.
With that in mind, your life insurance policy is designed to replace your income and finance your family or spouse after you die. Because of this, many individuals may purchase a life insurance policy with enough coverage to pay off any debts while providing a financial safety net. Therefore, your beneficiaries can choose to use the death benefit to pay off your outstanding debts after you pass away.
Here are some of the most common situations when a living relative or spouse is required to pay off debts for the deceased and can use the proceeds from a death benefit:
When living in community property states: If you live in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin, your spouse becomes responsible for any debts you took over the duration of your marriage.
If your state has filial responsibility laws: As dictated by state laws, long-term care facilities and nursing homes require surviving offspring to pay off their decedent parent’s outstanding medical bills. Given this, the policy’s proceeds or cash value can also be used to cover these expenses.
If you cosigned a loan: Some loan options offer borrowers the chance to have a cosigner. In this case, regardless of their relation to you, your cosigner would take responsibility for paying back the loan when you die.
If you have a joint account: If you have a joint bank account or credit card with another person, both parties are responsible for any debt and unpaid monthly fees. Do note that joint ownership is not the same as having a dependent or authorized user on an account.
How To Protect Your Life Insurance From Creditors
When a beneficiary loses their claims on a deceased loved one’s life insurance proceeds, it can be devastating. But what can a policyholder do to make sure their outstanding debts don’t get in the way of providing a financial failsafe for their families and loved ones? This section outlines three concrete pieces of advice that all policyholders should consider when planning around their existing debts.
Don’t Name Your Estate As Your Beneficiary On Your Life Insurance Policy
When you die, your estate goes through probate. This involves a court evaluation of your property, assets, final wishes, and unpaid debt. Through this process, creditors may appropriate parts of your estate to cover owed debts before the remains are dispersed to any individual beneficiary.
That’s why we recommend being especially mindful during the estate planning phase. Many policy owners name their estate as their life insurance beneficiary as a way of distributing their death benefit among multiple heirs. In this case, however, the proceeds from their life insurance policy are usually distributed to creditors before a named beneficiary. The size of your debt then determines the amount that a person in your will receives.
However, there is one simple way to secure your death benefit and ensure that the people you love are taken care of: naming each individual beneficiary instead of your estate. Doing this bypasses probate and allows your life insurance company to deliver the proceeds and death benefits directly to your spouse or heirs.
Keep Every Named Beneficiary Up To Date
Many life insurance options allow naming more than one beneficiary, but each policy owner must keep the information on their plan up to date. Otherwise, your plan’s cash value and proceeds may default to your estate.
Case in point: if your named beneficiary predeceases you, then nobody will be around to collect their claims or benefits when you die. This can be problematic because your surviving child or other family members may have to jump through legal hoops to gain access to the money you meant to leave behind. Additionally, some states may subject proceeds to costly estate taxes.
With this in mind, we recommend designating both a primary and secondary beneficiary on your insurance policy. Having more than one beneficiary means that your death benefit will always go to your family instead of creditors.
Buy The Right Insurance Policy To Cover Your Debts
One thing every person has to consider when applying for a life insurance policy is how much coverage they’re supposed to get. This consideration is especially critical if you have long-term debts like mortgages or other loans because your life insurance exists to protect your family from significant financial burdens. That means your life insurance policy should be enough to cover your debts.
For example, if you have a $350,000 mortgage that you plan to pay off over the next 20 years, then you’ll want to factor that in during the application process. Otherwise, your creditors may attempt to use the policy’s payout to settle the balance, which leaves your designated beneficiary with a smaller benefit.
Frequently Asked Questions
Can I use my life policy to pay off debts when I’m still alive?
It’s entirely possible to use your policy to settle your debts – but this can come at significant risk to your beneficiary. Some policies come with a cash value component, which essentially functions as a savings account within your policy. It can be accessed in two ways if you need to pay off your creditors:
Surrender your policy: Surrendering your plan will “release” your accumulated cash value and allow you to pay off any pressing debts. However, this does void all coverage from your insurer.
Take out a loan with your insurer: Borrowing from your cash value is essentially taking a loan with your insurer. This can be a great option for people looking to consolidate their debt with lower interest fees.
Can I use my policy as collateral on a loan?
Using your policy as collateral on a loan is possible, but there is one major drawback. Creditors will have access to your loan’s payout before your beneficiaries. Therefore, if you don’t settle your balance before you die, your beneficiaries will only receive what’s left after your lender has subtracted the amount you owe.
Insurance policies exist to secure your family financially after you die, but sometimes debts can get in the way. That’s why we recommend protecting your policy proceeds from being used by creditors with the assistance of a financial expert. Contact us at Wesley Insurance, LLC to find out how we can help you!