Life insurance policy payouts are handled differently than other assets in cases of bankruptcy and paying the debts of the deceased. Life insurance payouts are protected from creditors under certain circumstances though what you do with the money once you receive it may be a determining factor in how a creditor may go after the cash. Once money is deposited in your bank account, it looks the same as the rest of your finances.
Life Insurance in a Bankruptcy
According to Free Advice's website, federal law allows you to exempt up to $10,775 of a life insurance policy's value in a bankruptcy proceeding. This means this value of the policy cannot be liquidated by the court to pay off your creditors. Any value above this protected amount, however, may be seized by the court and used to pay off your debts. Each state also may have its own laws relating to life insurance payouts in a bankruptcy or may opt to apply the federal regulations.
IRS Bank Levy
If the Internal Revenue Service has placed a bank levy on your accounts, any money you have in those accounts, regardless of where it comes from, is the property of the IRS. This means if your life insurance payout is housed in an account seized by the IRS, the entire payout could be wiped out in the name of paying off your tax debt. If you receive notice of a bank levy, you have 21 days to respond before your bank is required to release the funds contained in your accounts to the IRS. Contact both your bank and the IRS to determine if an equitable solution may be worked out before the seizure occurs.
Payouts Necessary for Support
If a life insurance payout is directly linked to someone on whom you were dependent for support, like a deceased spouse, the payout is entirely exempt from the bankruptcy process, according to Free Advice. This allows you to retain funds necessary to meet your everyday living needs without fear they may be taken to pay off a creditor.
Life Insurance and Debts of the Deceased
According to Bank Rate's website, life insurance typically passes outside of the decedent's estate. This means the payout amount is not available for seizure by creditors upon the death of the policy holder. The sum of the life insurance policy may pass directly to the surviving spouse or next of kin. Exceptions to this rule apply to any real property of the deceased which passes to you which still has a remaining mortgage or deed of trust. Life insurance in this case may be used to pay off the loan, leaving you with the property free and clear.
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