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You typically don’t buy life insurance with the intentions of it going into the hands of greedy creditors. While it might sound a bit insensitive for a creditor to dip into the funds that a grieving family is supposed to be using to live off of, it happens on a daily basis. It’s the policy owner’s job to ensure that this doesn’t happen. Start comparing life insurance rates now by using our FREE tool above!
One of the main reasons why this happens is because the insured doesn’t structure the policy correctly in the beginning or modify the structure after time. When it comes to buying life insurance, you’ll need to focus on more than just selecting a policy type, a death benefit or a carrier. It’s also important that you learn about the importance of structuring your policy so that the proceeds go to the ones that you love and not to bill collectors. Read this guide, and learn exactly what mistakes you should avoid.
What is a life insurance beneficiary?
When you’re filling out an application for coverage, you’re specifically asked to name a beneficiary. A beneficiary is either a person or a legal entity that will receive all or a portion of the death benefit upon your death as you designate in writing. You can choose the following to be named on your own individual policy as the recipient of life proceeds:
- A family member or loved one
- An irrevocable trust
- A trustee of a revocable trust
- A business partner
- A charity
- A business entity
- Your estate
The Importance of Naming the Right Beneficiary
When you buy life insurance young, you might not have a clue who you want to designate as a beneficiary simply because you don’t have a spouse or children. Unfortunately, failing to name a beneficiary could be the sole reason why the proceeds of the policy wind up in the hands of debtors and not of people who could use it.
If you don’t name a beneficiary or add a person, business, charity or trust while you’re alive, the life insurance proceeds that are paid out will be paid out to the estate.
This might not sound so bad, but it’s the consequences of the estate being a beneficiary that will affect your family long term.
How are life insurance proceeds paid to the estate treated?
There are a lot of exemptions for life insurance proceeds when it comes to taxation and when it comes to claims from debt collectors. Unfortunately, these exemptions only apply when there’s a direct named beneficiary. If you fail to name a beneficiary or you specifically name your estate, the proceeds from the policy will go through probate upon the insured’s death along with all of the other assets.
What happens if life insurance proceeds go through probate?
If the death benefit that’s paid by the insurance company does go through probate because the policy owner didn’t name a beneficiary, this could create both tax consequences and an opportunity for creditors to come knocking.
You might not be worried about debts after death, but they can come back to haunt you if your proceeds are in the estate.
The is because life insurance proceeds that are paid to the estate either because there’s no beneficiary or because the beneficiary has passed away becomes an asset. As an asset, the proceeds will be available to creditors that make claims on the debt that was owed by the decedent.
If there’s a named beneficiary, is there still a risk?
There is risk of creditors swooping in and eating up all of the proceeds before they are paid out to heirs is minimized when there’s a named beneficiary, but it’s possible that it can still happen in unique situations. Since life insurance proceeds are protected, it’s very unusual that someone listed on the policy. Here’s some scenarios that you should be aware of:
- The Decedent and Beneficiary Have Joint Debt- If the deceased was a co-signor on a loan with a beneficiary, the situation gets a bit hairy. In most states, the creditor can terminate the loan and collect on the debt by claiming against the insurance money. The purpose of this is to repay the loan because the co-signor is no longer living.
- Back Taxes through the IRS- Some things in life are certain and taxes are one of those things. If the benefactor had tax obligations with the IRS, it’s understandable that you might worry that the IRS would seize the death benefit. Luckily, if the deceased is the one who owed the money, that won’t happen. The IRS can go after assets in the estate but not proceeds named to someone.
You can pay these debts with the proceeds, but you’re not obligated to do so. If, however, you have liens because of your own back taxes, the IRS could learn that you’ve come into money and take that money to cover your obligations.
What if there are creditors after money owed by the beneficiary?
If the beneficiary has debt collectors on their tails, whether or not those debtors can take proceeds depends on when the debt was incurred.
If the debt was incurred before the payout, creditors can’t make a claim.
If, however, the beneficiary borrows money after the claim is made and defaults on that loan, a judgement creditor can file a claim and ask that insurance money be used to pay the debt. If there’s still money in the policy, a lien can be placed so that you can’t spend it.
As you can see, life insurance money is seriously protected so that it can be used by loved ones to pay off debts and to replace income. If you’re interested in planning for the future, knowing that these protections exist might help you see why life insurance is such a powerful estate planning tool. It’s now time to see just how affordable life insurance can be. Start by using a life insurance rate comparison tool and see what term or permanent insurance will cost. After you have the premium estimates, decide on a limit and a policy type. Compare life insurance rates now by entering your zip code in our FREE tool below!