What Debts are Forgiven at Death?

For the most part, creditors cannot take the life insurance payout from your loved ones even if they have outstanding debts. Because laws differ from state to state, how a policyholder’s unpaid debts are handled could affect your loved one’s inheritance, however. You will need to ensure your policy pays out according to your wishes and financially protects your family and loved ones. 

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Can Debtors Lose Money From the Death Benefit?

For the most part, creditors cannot directly take the life insurance death benefit payout from your loved ones if you — or your beneficiary — have outstanding debts when you die.

In general, only the beneficiaries listed on the policy are entitled to receive a death benefit when you pass away. The life insurance payout is typically protected from anyone who isn’t listed on the policy. That means your dependents are the only ones that can receive the policy benefits when you die. 

However, if your beneficiary owes money and receives a life insurance payout, that money is now considered their asset. If creditors sue them and win, they may be able to garnish bank accounts. Life insurance money held in those bank accounts could be at risk.

Things can get even more complicated if you listed your estate as your beneficiary or if your beneficiaries predeceased you. If your policy’s death benefit goes to your estate instead of to beneficiaries, then it can be used to pay your creditors through a process called probate.

If that happens, your insurer will pay out your death benefit to your estate, which in turn, could be turned over to your creditors to pay off any debts you have. Once your estate receives your death benefit payout, it goes through a probate process, and proceeds can be used to pay off outstanding debts with your creditors. Any remaining funds would then be dispersed with your estate as you instructed in your will. 

How to Protect Your Death Benefit From Creditors

It’s important to ensure your life insurance policy is set up so that your family and loved ones are not burdened with grief and financial instability when you pass away. 

• List your loved ones as the beneficiary, not your estate: When you pass away, the very people you're working hard to financially protect can file the death benefit claim and receive a life insurance policy payout in one tax-free lump sum. If you list your estate as the beneficiary, however, the life insurance payout goes through probate.
  
  
• Create a strong financial plan: You can protect your loved ones from dealing with the burden of your debts by setting up a life insurance policy that can cover lost income from your passing and long-term debts. For example, if you have a $300,000 mortgage over 15 years, you can add that amount to how much life insurance you want to buy.
  
  
• Make a plan and keep your beneficiaries up to date: While it’s important to make a solid financial plan for your loved ones for when you die, you also need to be flexible in revising that plan and keeping your beneficiaries up to date about your wishes. Check your policy regularly and update it as you experience significant life changes — deaths in the family, marriages, divorces and retirement. Just make sure to update your dependents of any changes you make so they're aware and can honor your final wishes. 

Is Paying Off Debt With an Inheritance a Good Idea?

While creditors might not be able to garnish your life insurance death benefit from your loved ones, your beneficiaries might be wise to use their inheritance to pay off outstanding debts. They are not required to do this, but it might make smart financial sense for them to eliminate high-interest debts if they have the extra funds.