Will My Creditors Take My Kids’ Life Insurance Money?

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Here’s another estate planning question, paraphrased from my Facebook Page:

Q: When I die, will the beneficiaries of my life insurance policies become responsible for my debts ?

A:  The short answer in Illinois is probably not.

Here’s the long answer:

[You know that lawyers can never give a simple answer to anything, right?]

As I mentioned in an earlier post, life insurance can be a powerful estate planning tool to provide for those you care about after your death.  But what if you have racked up a bunch of unpaid bills at the time of your death?  Do your life insurance beneficiaries have to pay off your credit cards bills, hospital bills, utility bills, etc.?

Take a look at the beneficiary designations on your life insurance policy.  Check to see if you have named individuals as primary and contingent beneficiaries.  If so, your beneficiaries are in luck.  The Illinois Insurance Code and case law interpreting its provisions state that a named beneficiary who is living when you die will receive the policy proceeds without no reductions for payment of your debts.

However, if you did not name a beneficiary, or if the named beneficiary is not alive when you die, the insurance proceeds will be paid to your estate.  In that case, your creditors may be able to file claims against your estate in probate court to get their hands on the policy proceeds.

Moral: Designate primary and contingent beneficiaries, review your designations periodically, and make changes as needed (e.g., if a named beneficiary dies).

Even if you designated beneficiaries for your policies and they are alive at your death, it is still possible that they will not receive the entire policy proceeds.  This problem can arise if your estate is subject to estate tax.  Estate taxes are federal and state taxes paid on the privilege of transferring property at death (more on estate taxes in a later blog post).

2010 is a strange year for estate taxes because they have been temporarily eliminated, only to return in 2011 when they will apply to estates worth over $1 million.  If your estate is subject to estate tax upon your death, your life insurance beneficiaries may be liable for a portion of the estate tax liability.

There are planning techniques to avoid estate tax liability on life insurance proceeds — by either transferring the policies into an Irrevocable Life Insurance Trust (ILIT) or having the ILIT trustee purchase the policies.  But that is a topic for another day.

Image credit to Svilen Milev.

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