Can I Use an Estate Plan to Minimize the Effect of My Debt on My Beneficiaries?

The bad news is that when you die, your personal debt not only lives on, but becomes the responsibility of your estate. The good news is that by planning ahead and taking time now to review your accounts, you can reduce the burden of your debt on your loved ones, and even protect certain assets from creditors.

When you die, your friends and family probably won't need to reach into their own pockets to pay your personal debts. However, your estate will have to pay your outstanding financial obligations, and these payments could reduce or eliminate gifts you plan to leave to loved ones. If you are worried about this possibility, you can use certain estate planning tools to reduce the impact of your debts and maximize the gifts you leave behind.

Paying Off Debts After the Debtor Dies

The impact of any debt you leave behind will vary based on your debt level, any steps you take during your lifetime to protect your assets from creditors, and the type of debt you owe.

Personal Debt

Generally speaking, personal debt dies with the borrower, and cannot be passed along to surviving family members. But this does not mean that the debt goes away. Instead, debts such as a credit card balance or an outstanding loan become the responsibility of your estate. A shared debt is a notable exception (see the section on shared debt below), and the rules are complicated in community property states, where debts incurred during the marriage generally belong to the couple (in common law states, by contrast, the debt belongs to the spouse whose name is on the deed, loan, or other instrument).

If your estate has the assets to cover your outstanding debts, your executor or administrator will need to pay these debts, along with any final bills, before distributing the remainder of your estate to your beneficiaries. If your debt is significant, this will almost certainly reduce and could eliminate gifts you intended to leave to loved ones.

But suppose the debt you leave behind exceeds the assets in your estate? A court will consider your estate insolvent when available funds are insufficient to pay all debts. At this point, state law sets the order in which the executor or administrator pays your creditors. Estate administration and funeral expenses are typically at the top of the list, with unsecured debt, such as credit card balances, at the bottom. When estate assets have run out, leaving creditors at the bottom of the list without a source of funds, your family will not be responsible for your personal debt. The debts will simply go unpaid.

Business Debt

When business owners die and leave business debt behind, the fate of that debt will depend on the business structure and any plans the owner had in place to deal with this eventuality. For example, unless the owner of a sole proprietorship made plans for the business to avoid probate, when the owner dies, the business will go through probate as part of the owner's estate. In that case, any debts of the business will be treated as personal debt and the executor will pay them using estate assets.

If your business is a limited liability company (LLC) or a corporation, most of the time the business’s creditors can look only to the assets of the business to satisfy their claims. (In some states, unless the LLC’s operating agreement provides otherwise, the death of an LLC member can trigger the LLC’s dissolution and payment of business debts.)

Estate Planning Tools That Will Protect Your Estate

A will and a living trust are estate planning tools that allow you to name who will inherit your assets. A trust can help you avoid probate, protect your privacy, and reduce estate settlement costs. For this reason, many people prefer it to a will, which incurs probate fees and is a public document. With each, however, creditors are paid before beneficiaries. That said, each offers limited protections:

  • Specify who will be paid first. You can set the distribution order in either a trust or a will. You can also include provisions on how you would like your debts to be paid. For example, suppose you want your nephew to receive your vintage car, no matter what. Writing directions to this effect could help ensure that your car is left intact (not sold to produce liquid assets) and gifted according to your wishes, while other assets are sold to cover your debts per your instructions.

  • Allocate gifts based on percentage amounts. Typically, an executor pays debts using assets that are not specific bequests, like your stamp collection, or general bequests such as specific cash gifts. But in the case of significant debt, when most or all assets need to be sold to cover final debts and expenses, some or all of the cash and specific property you intended for your loved ones may not exist. If this is a possibility, you can use fractional or percentage amounts to divide your estate, which could help direct a small inheritance to certain loved ones. By allocating percentages, even when your debts wipe out most of your estate, your executor will distribute any remaining assets in the shares you specified. The actual amount will vary depending upon your final debt, but percentages could help ensure that designated loved ones inherit according to your wishes.

When people decide whether to use a will or a trust, they’re usually not deciding based on evading creditors’ claims. But it should be mentioned that a will has one feature missing from a trust: When a court probates your will, it notifies creditors of a cutoff date for filing claims against your estate. Creditors who don’t file claims in time are out of luck. While a trust does not have this hard stop feature, the trustee is charged with finding and paying creditors. When asset distribution precedes debt settlement, creditors can go after those assets to satisfy your debts, even though they are technically no longer part of your estate. Fortunately, taking additional steps, explained below, can help protect your assets from creditors

Take Steps to Keep Assets Out of Creditors’ Reach

While creating a will or a trust will certainly clarify and simplify the disbursement of your belongings when you die, these tools will not prevent a creditor from making a claim on your assets. To effectively prevent claims, you’ll need to make sure that assets never enter your trust or your estate in the first place. Here are ways to keep assets away from those arenas.

Beneficiary Designations

By naming a specific individual beneficiary on IRAs, brokerage accounts, life insurance policies, retirement plans and pensions, 401k plans, and any other accounts you have that allow you to name a beneficiary, you ensure that these assets will pass outside your estate and directly to your beneficiary. They cannot be used to pay your debts. For bank accounts, a payable-on-death designation works in much the same way.

When naming a beneficiary for your various accounts, be sure to name an alternate or contingent beneficiary, too. That’s important in case your primary beneficiary passes away before you do. In that event, without an alternate or contingent ready to step up, the designation will fail and the funds will go into your estate—exactly the result you are trying to avoid. Your account manager or representative can let you know if you have a beneficiary designation on file, and instruct you on how to add to or change it. It’s a good idea to review your beneficiary designations periodically.

Life Insurance

Another way to minimize the impact of debt on your beneficiaries is to purchase life insurance, whose payout will go directly to your intended beneficiary. In most states, the proceeds are fully exempt from creditors. If your debts exceed the value of your reachable assets, life insurance may be the only money that your loved ones receive.

Life insurance companies typically process claims quickly, making cash available to cover funeral and other expenses. That cash might be much appreciated if your estate is short on funds, requiring others to pay for these expenses with a loan or a credit card. While those expenses will be reimbursed later by your estate, your loved ones will be out of luck if the estate is insolvent.

Life insurance proceeds could also help someone who inherits and wants to keep an asset (such as a house or a car) that has not been paid off. The debt owed on the mortgage or car loan typically stays with the asset, so that the beneficiary inherits not only the asset, but the debt, too. Your beneficiary could use your life insurance proceeds to pay down or pay off the mortgage or car loan. If your executor needs to sell the house or car to pay your debts, your intended beneficiary will not inherit the asset or the associated debt, but will still receive the life insurance proceeds.

Joint Ownership

Joint ownership can in some instances help minimize debt, or at least protect certain assets from creditors. For example, if you and your spouse have a joint bank account with right of survivorship, the funds in the account will pass immediately and directly to your spouse at your death. In states that permit owning property as tenants by the entireties, where each spouse owns a half-share, this property is usually subject only to claims for debts that are the joint responsibility of both spouses, and generally cannot be reached by creditors for your personal debts.

Shared Debts May Need Special Consideration

Responsibility for shared debts can vary based on the type of account, its terms, and applicable laws, but if your debt includes joint accounts or loans with cosigners, planning ahead can have important benefits.

  • Joint credit cards. If you have a joint credit card account, it is co-owned by you and the second individual. In most cases, the second credit card holder on your joint account will be liable for the credit card debt no matter who made the purchases. If instead, you have an authorized user on your credit card account, this debt is treated as your personal debt, and the authorized user is not liable to your creditors. The outcome is different if your spouse is an authorized user on your credit card and you live in a community property state, where debts incurred during the marriage generally belong to the couple, and creditors can pursue payment from your surviving spouse.
  • Cosigned loans. If you pass away and someone has cosigned a loan or line of credit for you, your cosigner will be responsible for paying the debt if the assets in your estate cannot cover the full amount. This could deal a heavy and unexpected blow to your cosigner’s finances. Taking steps now, such as making small additional payments on the loan, naming your cosigner as a beneficiary on a life insurance policy, or investigating whether the debt can be separated during your lifetime, could help to protect your cosigner.

The impact that your debt has on your assets and your beneficiaries can be minimized by taking the time to check beneficiary designations, and when possible paying down debt or purchasing life insurance. If you’re concerned that your estate might be insolvent, life insurance proceeds can help take the sting out of final expenses, which can generate significant debt for your survivors. If you have specific concerns about your debt, assets or beneficiaries as you plan your estate, an estate planning lawyer or financial planner can provide you with guidance expressly tailored to your situation.

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