Death and disability often lead to financial hardship from losing the income of the individual who dies or becomes disabled.

People can minimize the impact by purchasing term life insurance and individual disability insurance policies.

While the insurance benefits are designed to help families and beneficiaries, can creditors collect some of those proceeds to cover the debts of the insured?

Creditors and life insurance

In general, your debt becomes the responsibility of your estate following your death. Whether your life insurance policy benefits can be claimed by creditors depends on who — or what — is named the beneficiary.

Assuming a spouse, child, or other living person is named as a primary or secondary beneficiary, the proceeds from the life insurance policy pass directly to them. The death benefit avoids probate, which is the process of a deceased person’s estate being settled and debts paid. In essence, the death benefit from your insurance policy is not part of your estate and does not have to be distributed to creditors.

Because life insurance benefits become the property of the beneficiary at disbursement, they also cannot be seized by the IRS to pay tax debt. In fact, the IRS is prohibited from garnishing life insurance premium payments and benefits.

Situations in which life insurance proceeds are not protected

However, if the named beneficiary(s) is no longer living when the insured dies, the proceeds could pass into the decedent’s probate estate and become available to pay his or her debts. This depends on how the laws of your state govern these situations. In some cases, a court may provide the proceeds to the closest living relative.

That’s one of the reasons it’s important to regularly review and, if necessary, update beneficiaries on life insurance policies.

Life insurance proceeds would also enter the probate process if the insured’s estate is named the beneficiary.

Debts may still have to be paid somehow

Just because life insurance proceeds avoid probate doesn’t mean the money won’t eventually be needed to settled debts.

If there is a co-signor on any loan and that person is still alive, he or she now owns the debt and must repay it.

For example, if you co-own your home with a spouse, he or she must continue paying the mortgage after your death. With a sufficient life insurance death benefit, the spouse can either pay off the full mortgage or continue making monthly payments.

In community property states, all assets and liabilities acquired during a marriage are considered to be owned by both spouses, even if the spouse did not co-own, co-sign, or hold joint account status. This essentially means that in these states, joint ownership is automatically presumed by law.

Your surviving spouse is liable for all debts that occurred during the marriage in community property states, which are:

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

Creditors and disability insurance

If you become disabled due to injury or illness and have trouble paying off debts, you can also be somewhat assured that your disability insurance benefits will remain shielded from creditors.

Many states protect private disability insurance benefits from being seized or garnished by creditors. And the federal Consumer Credit Protection Act protects a portion of your disability payments from collection.

However, your debts will remain your responsibility if because of a disability you can’t work at all or have to work less.

This is especially true if you own the property that secures a loan, such as your house and car. If you want to continue living in your home and still owe on your mortgage, you must continue making payments or risk foreclosure. Your vehicle can be repossessed if you neglect payments. For unsecured debt like credit card debt, you still are responsible for repayment.

The best way to cover your debts

Although your insurance benefits are primarily shielded from creditors, they are also the best way to protect you and your family from loan default, collection actions, and adverse credit is to insure your income against the risks of death and disability.

Life insurance can provide the funds needed to pay off your debts and obligations if you pass away. Physician disability insurance can provide the needed income to keep you from falling behind on your mortgage or car payments, racking up more debt, or being forced to find other sources for needed cash.

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What Happens to Your Debt Upon Death or Disability?