Can creditors take my life insurance?

You’re getting a life insurance policy to ensure that your loved ones are financially secure after your death — but can lenders take it from them?

Nupur Gambhir

Nupur Gambhir

Published May 7, 2020

KEY TAKEAWAYS

  • Creditors cannot take the death benefit from your beneficiaries if you have outstanding debts when you die

  • If your policy’s death benefit is paid out to your estate, then it can be paid to creditors through a process called probate

  • The best way to guarantee creditors won’t get to claim the death benefit is to list your dependents as your beneficiaries and keep your policy up to date

Your life insurance policy is meant to provide peace of mind to your loved ones by ensuring their financial protection when you are no longer around.

Debt accumulation is, unfortunately, increasingly becoming a part of American life. As of 2018, only 23% of Americans live debt free and the average household has a staggering $53,850 of debt. If you die unexpectedly and leave some debt behind, it can fall on the shoulders of loved ones. But you’re getting a life insurance policy for the assurance that your loved ones are going to be taken care of when you die — so should you be concerned that the protection you’re paying for can be taken from them by lenders?

For the most part, creditors cannot take the death benefit from your beneficiaries. But, a few small mistakes could increase the risk of that happening. Here’s what you should do to ensure that your policy pays out the way you intended it to— and protects the financial security of your loved ones.

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Can creditors take money from the death benefit?

If the death benefit is paid out to your beneficiaries and you have outstanding debts, creditors can’t swoop in and take the life insurance payout from them. Life insurance is generally protected from outside access by anyone who isn’t listed in the policy. Only the beneficiaries listed in your policy can receive the death benefit, meaning life insurance companies won’t pay out to an unlisted creditor — at least not directly.

What creditors will have access to is your estate and assets, which will go through probate when you die. Depending on the type of debt you have, it can become a part of your estate when you die and might be seized to pay lenders since you’re no longer around to do so. Life insurance is exempt from this process and the death benefit will go directly to your beneficiaries, regardless of any outstanding debts you owe.

Things can get complicated if you’ve listed your estate as your beneficiary — then your death benefit is fair game to creditors. Or if your beneficiaries have predeceased you, then your insurer will pay out your policy to your estate.

How creditors can access the death benefit

Though creditors can only access the death benefit if it’s a part of your estate, there are two different ways that this can happen:

  • 1. You list your estate as your beneficiary.
  • 2. Your beneficiaries predecease you and your death benefit is then paid out to your estate.

Once the life insurance death benefit is paid out to your estate, it becomes a part of the probate process and can be paid out to creditors to repay outstanding debts. If, after this process, there is any death benefit left, it will then be dispersed with your estate as you intended in your will and testament.

How to ensure your death benefit is protected from creditors

Even when you have the right financial protections in place, if you have outstanding debts, there are a few guidelines to be cognizant of so that your loved ones aren’t negatively impacted.

Don’t list your estate as the beneficiary

When you die and your estate goes through probate, a probate court will evaluate your assets, final wishes, and unpaid debts. Your estate is dispersed to creditors to cover your outstanding debts before it goes to any beneficiaries you listed in your estate plan.

While a life insurance policy won’t directly go to creditors, if you’ve listed your estate as the beneficiary with the intention of it being dispersed amongst your heirs, then creditors will get to access the funds before your intended beneficiaries do. Any remaining assets — or in this case, death benefit — in your estate would then be dispersed according to your wishes.

The best way to make sure this doesn’t happen is to list the very people you’re trying to financially protect as your beneficiaries. Once they file the death benefit claim, the money will go directly to them as a tax-free lump sum and you can rest assured that they’ll have access to the money.

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Keep your beneficiaries up to date

You can have the best of intentions when listing your beneficiaries in your policy, but if they predecease you and nobody in your policy is alive to accept the death benefit, it will be paid out to your estate and you’ll experience the same problem that we listed above.

The best way to prevent this is to think of your policy like a fine-tuned car. To keep it running as it should, you need routine check-ups. The same goes for your life insurance policy — you want to check up on it regularly and always keep it up to date, especially as you experience big life changes, like a death in the family or a divorce.

Updating your life insurance beneficiary is relatively simple and usually only requires logging into your online portal to do so. You can also list more than one beneficiary and contingent beneficiary, who will get the death benefit if the primary beneficiaries aren’t alive to accept it.

Make sure that you’re always adjusting your beneficiaries as necessary so that the people who rely on you for financial protection get it.

Set up a robust financial safety net for your beneficiaries

Even if your death benefit goes directly to your beneficiaries, you can protect them from shouldering your debts when you die by setting up the right life insurance policy. While life insurance should replace the income you provided for your dependents, you also need to think about any debts you owe and ensure that your policy covers your loan amount and if it’s something like a mortgage, the loan’s length.

For example, if you have a $500,000 mortgage over 20 years, you’ll want to add in that potential cost with its interest when you’re getting your life insurance policy, on top of getting coverage that is 10 to 15 times your income. Likewise, your policy should last at least the entire 20 years to cover the mortgage’s term length.

What types of debts can become a part of your estate?

Not all debts are going to fall on the shoulders of loved ones — federal student loans and some private student loans are forgiven when you die. But most private student loans and mortgages are going to become a part of your estate while any loans that you signed with a cosigner become the responsibility of the people you leave behind.

Who takes on your debt?

It’s important to note that even though a creditor might not be able to take the life insurance death benefit from your beneficiaries, they still might end up being responsible for paying your loans. This is why it’s important that you get a life insurance coverage amount that covers not only your anticipated costs but also any debts you might have to pay off.

Married couples in community property states will need to be extra vigilant about this, as your spouse will be responsible for any debts you took on during the marriage after you die. (In a community property state, one spouse’s debt is another spouse’s debt). There are nine states that have such community property laws in place:

  • Arizona
  • California
  • Idaho
  • Louisiana
  • Nevada
  • New Mexico
  • Texas
  • Washington
  • Wisconsin

Additionally, if you live in a state with filial responsibility laws, a parent’s debt can become their child’s after they die. In these states, children may be liable for a parent’s medical bills, nursing home care, or long-term care.

Can you use your life insurance policy to pay off debts?

In its purest form, life insurance is meant to be utilized as an income replacement for your dependents after you die. But there are ways that your policy can be utilized to accommodate any outstanding debts — though usually at the detriment of your dependents.

Cash value

The cash value is an investment component that is included in some permanent life insurance policies. With cash value policies, part of the premiums you pay contribute towards the cash value and are tax-deferred. The cash value can be used in a few key ways to support outstanding debts:

  • You can surrender your policy and use the accrued cash value to pay off debts
  • You can take out a loan against the cash value of your policy, and accrue debt

Both have serious implications for your beneficiaries. If you surrender your policy, your dependents won’t receive any death benefit when you die. And if you take out a loan against the cash value without repaying it before you die, whatever you owe will be deducted from the death benefit.

Using your policy as collateral on a loan

Another way to lose your life insurance policy? Using it as collateral against a loan. This is called collateral assignment and is utilized by small business loans or Small Business Administration (SBA) loans to ensure that they’ll receive payment for any loans they shell out.

If you utilized collateral assignment and then died without fully repaying your loan, whatever you owe will be taken from the death benefit. Any remaining death benefit would then go to your listed beneficiaries.