Life insurance policies are meant to help your loved ones if tragedy strikes. What you may not realize is that life insurance can also help your creditors. If you're being sued for debts or if you file bankruptcy, your creditors might try to get hold of your life insurance holdings. If you're concerned, you should find out if your life insurance policy is protected from creditors and if any of these protections have limitations.
Exactly how much of your life insurance benefits a creditor can take depends on individual state regulations. Some states protect life insurance policies from creditors, while others offer only limited protection. In Florida, all cash value life insurance policies are protected from creditors while the insured is alive. After death, however, the benefits are not protected and creditors can take money from the value of the policy before it's passed on to the beneficiaries. In Texas, by contrast, both the cash value and death benefit of life insurance policies are wholly protected from creditors, except for cases of fraud.
Cash Value of Life Insurance
There are many different types of life insurance policies. Cash value policies, such as whole-life insurance, deposit your premium into a cash account after subtracting insurance costs and other expenses, often including an annual charge. These policies usually have minimum dividends of two to four percent. You can withdraw cash at any time, but you might be taxed on the withdrawal. One downside to these policies is that some people can't pay the yearly premium and end up having to cancel the policy. When you die, your family receives only the value of the policy, not the amount of cash you put into it. In contrast, term life insurance policies last for a limited period of time, such as 20 years, but the monthly premiums are much cheaper.
There are a few situations that can make a life insurance policy more vulnerable to the claims of creditors. If the policy names beneficiaries who are alive at the time of the insured person's death, but they co-signed any debts with the deceased, then the creditors can sue to use the life insurance payout to cover the debt. If the beneficiaries did not cosign on any debts, they may still need to use some of the life insurance payout to cover estate taxes. If the policy names the estate as the beneficiary, or if the named beneficiary died, then the life insurance payouts are especially vulnerable. The estate may need to liquidate its assets, including life insurance, to repay creditors before it can give payments to any heirs.
If you want a cash value policy but also want to avoid creditors' taking money from it to pay off debts, you might consider creating an irrevocable trust to help your situation. Transferring your life insurance policy into the irrevocable spendthrift trust might help because these trusts are exempt from creditors. With these trusts, you no longer have access to the funds within them, so your creditors can't compel you to use the assets to pay off your debts. Instead, all assets in an irrevocable trust are transferred to an independent trustee who controls how they are given to the named beneficiary.
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