Debt accumulation is, unfortunately, a part of American life. Americans report spending 32% of their monthly income on paying down existing loans, [1] and the average household debt in the U.S. is $101,915. [2] Carrying debt is one of the main reasons to buy a life insurance policy — your dependents can use the proceeds to pay off what they owe.
In most cases, your creditors can’t take the death benefit from your beneficiaries. But, co-signed loans and outdated beneficiary listings can put your life insurance policy proceeds at risk.
Here’s how to make sure your policy pays out as intended and financially protects your loved ones.
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Can creditors go after my life insurance benefit?
Insurance regulations prevent creditors from taking the life insurance death benefit from your beneficiaries even if you have outstanding debts. Only the people listed in your policy can receive a payout, so life insurance companies won’t pay out to an unlisted creditor.
However, creditors can take the death benefit if it becomes part of your estate. This can happen in these scenarios.
If all of your beneficiaries die before you and you never name new ones
If you list your estate as a beneficiary
Your estate goes through probate court — a legal process that determines where your assets go — when you die.
Lenders are entitled to those assets and can claim any life insurance money that becomes part of your estate before your loved ones get their share. If there’s any money left after this process, it’s distributed according to your will.
Regulations protect your beneficiaries from your creditors, but if they’re in debt, they’re not protected from their own lenders. Once they receive the death benefit it becomes part of their assets, which can be seized if they’re past due on their own loans.
How to protect your life insurance from creditors
There are a few guidelines that can guarantee your loved ones get the protection you planned for.
Be specific when naming beneficiaries. You can list beneficiaries by name and title (Jane Doe, spouse) or using broader terms (Current spouse). Listing someone by name and their relationship to you is always better because it leaves no room for confusion.
Don’t list your estate as a beneficiary. Naming your estate exposes the death benefit to creditors and ties the money up in legal proceedings.
Keep your beneficiaries updated. If none of your beneficiaries can accept the death benefit, the payout goes through probate. Update your policy during major life events, like a divorce, marriage, or death in the family so that your policy pays out as planned.
Name a contingent beneficiary. A secondary tier of beneficiaries can accept the death benefit if none of your primary beneficiaries can do so, saving the money from probate.
→ Learn more about who you should never name as your life insurance beneficiary
What types of debt can become a part of your estate?
Not all debts fall on the shoulders of loved ones. Federal student loans and some private student loans are forgiven when you die.
Most private loans, however, can be recouped from your assets. Any debt that was co-signed or in a shared account becomes the responsibility of the people you leave behind.
Who takes on your debt?
Even though a creditor can’t take the death benefit from your beneficiaries, your family can still become responsible for your loans. This is why it’s important to buy enough life insurance coverage to protect not only your income but also any debts that can be passed on.
Married couples in community property states — where all assets are shared with your spouse once you’re married — should be extra vigilant about this.
After you die, your spouse is responsible for any debts you took on during the marriage. Nine states have community property state laws in place: [3]
Arizona
California
Idaho
Louisiana
Nevada
New Mexico
Texas
Washington
Wisconsin
Some states with filial responsibility laws will hold you responsible for a parent’s debt. Thirty states and the District of Columbia currently have filial responsibility laws. [4] The specifics vary by state, so consult a financial advisor if your parents are carrying debt.
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Can you use your life insurance policy to pay off debts?
Life insurance is meant to be an income replacement for your dependents after you die. But there are some policy options you can use to pay off loans while you’re alive. The tradeoff is that they can put your beneficiaries at a disadvantage.
Cash surrender: The cash value is an investment-like account included in most permanent life insurance policies. You can cash out your policy, but you’ll lose life insurance protection and may pay taxes or penalties.
Collateral assignment: Some lenders let you use your life insurance as collateral for a loan. If you die before repaying, the creditor recoups its money from the death benefit and only the remainder goes to your beneficiaries.
Credit life insurance: A type of decreasing term life policy often tied to mortgages, credit life covers a specific loan and only benefits your creditor. You need additional coverage to provide for your family.
Policy loan: Some insurers also allow you to take out a loan using your permanent policy as collateral. If you don’t repay your loan, it’s subtracted from the death benefit when you die.
Viatical settlement: Elderly or critically ill policy owners can sell their life insurance policy for cash. In addition to losing coverage, you’ll get a fraction of the death benefit in return and pay high taxes and fees.
Understanding how death benefits are distributed and how different policy options affect your coverage will help you provide maximum financial support to your loved ones.
As long as you manage your beneficiary designations carefully, the proceeds from your policy will be safe from creditors.
More about life insurance and financial planning
Frequently asked questions
Are life insurance policies protected from creditors?
Yes, most of the time. Creditors can go after life insurance if it becomes part of your estate, which happens if you name your estate as beneficiary or all of your beneficiaries die before you.
Are my beneficiaries responsible for your debt when you die?
It depends on the loan. Creditors can go after your assets for private loans and your loved ones are responsible for any debts you shared.
How do you protect your life insurance proceeds from creditors?
Make sure your beneficiaries stay updated so that the policy will never pay out to your estate and need to go through probate court.
