When someone passes away, their unpaid debts don’t just go away. It becomes part of their estate. Family members and next of kin won't inherit any of the outstanding debt, except when they own the debt themselves. (This usually happens if they are co-signer, joint account holder, or a surviving spouse in a community property state.)
Even when family members or loved ones are not responsible for the deceased’s debt, they may still be affected by it. If the unpaid debts are larger than the estate is worth, it can potentially reduce the inheritance that was left for beneficiaries.
Fortunately, certain assets (life insurance policies and retirement accounts, for example) typically can't be used to pay your debts, so they can pass safely to beneficiaries. This is why they can be an essential part of estate planning.
But no matter how good you are with your finances — whether you always make timely payments or are in need of better debt management — it’s important to know how an outstanding balance can affect your loved ones and family. We’ll take a look at what happens to your debt when you die and the consequences on those you leave behind, and how you can prepare.
What happens to debt after death?
When someone dies, their debt becomes part of their estate, which is a collection of everything they owned. An appointed executor will settle any outstanding debt, including tax debt, and keep up with payments using money from the estate. This is all part of the probate process.
Secured debts, like a car loan are backed up by collateral, which are assets that can be seized to pay off debt. If the deceased person had an auto loan, the bills must continue to be paid or else the lender could repossess the car. The same goes for a home loan or mortgage. The executor must continue making payments while the estate affairs are being settled.
To determine how your assets and belongings in the estate are distributed after your death, you need a will or trust.
If the deceased person is heavily in debt, at the discretion of the executor and depending on the terms of the will, some of the deceased’s assets may need to be sold off to pay creditors. The executor must pay all debts before any assets can be distributed to future heirs.
Unsecured debt, like personal loans and credit card debt, does not have any collateral backing it. If the estate runs out of money before all debts are paid, then it will likely be very hard for the lenders of unsecured debt (like a credit card company) to recoup this money. In this case, the debt will die off with the deceased.
Is debt forgiven when you die?
Federal student loans are forgiven, or discharged, if the student dies. Private student loans may also be forgiven at death, but many private lenders do not offer this type of forgiveness. In both cases, student loan debt will pass on to co-signer if there is one.
Is your family responsible for your debt when you die?
When someone dies, their outstanding debt does not automatically pass onto family members or next of kin, except in the following circumstances:
You live in a community property state
In nine states, both spouses own an equal share of everything acquired during the marriage including property, bank accounts, and debt. Generally, the surviving spouse will be responsible for any unpaid debts.
You live in a state with filial responsibility laws
Over half the states have laws holding children for their parents’ medical bills, particularly in the case of nursing homes or long-term care. Nursing homes can be very costly, so you might consider getting a long-term care insurance policy or speaking with an elder law attorney to plan ahead.
You are a co-signer
When you take out a loan, you often have the choice to add a co-signer. A co-signer is a co-owner and bears equal burden of responsibility for the loan. Co-signers will assume any debts after another co-signer has passed away.
For example, if you and a parent both cosigned on your student loans, should you pass away first, the parent will be responsible for the loan debt.
The idea of sharing financial responsibility with someone else can seem daunting and potentially dangerous, especially if your co-signer isn’t too good with their finances.
However, co-signing debt is not always a negative thing. If you have a lower credit score or a lower income, co-signing might be the only way to get a loan. Co-signing can also let an asset more easily transfer ownership. For example, if you cosigned on a mortgage with your spouse, when your spouse passes away, you will have to continue making mortgage payments as usual and keep the house. If however your spouse was the sole owner of the mortgage, depending on your circumstances, the lender may make it difficult for you to assume the mortgage into your name or allow you to make mortgage payments. You can speak with an estate planning attorney for more information.
You are a joint account holder
If you have a joint credit card account with someone who passes away, you will still be responsible for the payments. If you are not a joint account holder, you will not be responsible for a family member’s credit card debt and it is illegal for credit card companies to ask you to pay any unpaid bills. You should consult a lawyer if you are receiving calls from debt collectors who claim you must pay someone’s credit card debt.
Additionally, authorized users are not account holders, so they will not be responsible for the unpaid credit card debt either. However, any unpaid credit card bills can negatively affect the authorized user — they may see a dip in their credit score since credit bureaus will still look at that account when conducting a full credit report.
What assets are safe from creditors?
As mentioned, in the case that the deceased person had a lot of outstanding debt, that debt can wipe out the potential inheritance. However, there are other ways to leave money for your beneficiaries without worrying whether or not it will be used to pay off your unpaid bills.
Certain assets, many of which are usually not subject to probate, do not become part of the deceased person's estate in most cases and cannot be used to pay debts.
You can designate a beneficiary of your retirement accounts (like a 401k or Roth IRA to receive your investments when you pass away. This money cannot be taken away from your beneficiaries to pay off outstanding bills.
A life insurance policy is also protected from creditors. The beneficiaries can use the money however they’d like; that’s why life insurance is such an important part of estate planning.
Term life insurance, which lasts for a specific amount of time, is usually an affordable option for most people. You can even put your insurance policy in an irrevocable life insurance trust (ILIT) if you’re looking to reduce a potential estate tax.
Assets in a trust are not subject to probate, but furthermore, assets in an irrevocable trust, or a trust that can't be modified, cannot be used to pay for debts and liabilities accrued by the estate. Asset protection from creditors is one of the main benefits and reasons why people choose to open an irrevocable trust.