Life insurance is one of the more flexible elements of estate planning. You have a lot of options when determining what to do with your policy. You may want to designate the proceeds to pay off liens against your property so it passes to your beneficiaries unencumbered, or you might want to use it to provide your loved ones with ready and available cash. In either case, your beneficiary doesn't have to pay off your debts with the death benefits provided you take steps to prevent it.
Your beneficiary can take some steps to avoid probate so that your life insurance proceeds do not have to be used to pay for your debts when you pass away. There are exceptions when you have co-debtors, though.
Considering Your Estate
For the most part, your estate is responsible for any debts you leave behind when you die, whether they're secured or unsecured. If you can't pre-plan and pay everything off before your death, your creditors can make claims for what you owe against your probate estate.
Typically, the only way your life insurance proceeds would pay for these debts is if you name your estate as the beneficiary. You might do this to avoid having your executor liquidate assets to cover taxes, debts and other liabilities.
In most states, creditors have only a limited amount of time in which to make such claims. If they don't act before the deadline, your estate typically doesn't owe them anything.
Naming Your Beneficiary
If you name a loved one or a family member as beneficiary of your policy instead of your estate, the death benefits avoid probate. The probate process is necessary to transfer ownership of your assets after your death, but a life insurance policy is a contract with your insurer directing that your insurer pay the proceeds to a certain individual or individuals.
Therefore, the policy doesn't require probate and without probate, your creditors don't have access to the proceeds. They cannot legally make a claim against your beneficiary instead. In some states, such as Arizona, life insurance policies are immune from creditors by law.
Exploring Exceptions to the Rules
Exceptions to the usual rules exist when co-debtors are involved. For example, if you and your spouse are jointly liable for a debt, she becomes responsible for the entire debt when you die. You both signed a contract with the lender at the time you took the loan, agreeing to be responsible for paying it. If one of you can't do so, the creditor has the right to look to the other for payment.
This is true regardless of whether you name your co-debtor as beneficiary of your life insurance policy. If you name your estate as beneficiary, however, your estate has the option of paying off the balance with the proceeds so that your spouse doesn't have to. In community property states, your half of marital assets – as well as any separate assets you hold at the time of your death – are vulnerable to joint creditors as well.
Considering Another Option
Living trusts bypass probate, just as assets do when they pass to beneficiaries by contract. If you name your trust as the beneficiary of your life insurance policy, different rules apply, but they may depend somewhat on your state's particular laws. For example, in Ohio, courts have ruled that creditors can't make claims against a trust the way they can if you pass your property by will. You can also create a life insurance trust to avoid leaving the ultimate decision to a court.
Life insurance trusts are irrevocable – you either transfer ownership of your policy to the trust, or you create the trust and direct the trustee purchase the policy. In either case, the trust is named as beneficiary and assets in irrevocable trusts are off limits to creditors. You can set up your trust to transfer the death benefits to the beneficiary or beneficiaries of your choice, and your creditors cannot reach the proceeds.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.