Life insurance policies can be protected in bankruptcy, but this depends on the type of policy and bankruptcy. If you have a term life insurance policy, it typically does not accumulate cash value, meaning it cannot be used to repay creditors. Whole life insurance policies, on the other hand, often accumulate cash value, which can be used to repay creditors. In the US, there is a federal exemption of $13,400 to $14,875, meaning any value over that amount is subject to seizure. If you are considering cashing out your life insurance policy before filing for bankruptcy, it's important to understand the different types of policies and their eligibility for cash-out, as well as the impact of bankruptcy on your future ability to use credit and borrow money.
What You'll Learn
Cashing out a life insurance policy before death
Whether you can cash out your life insurance policy before death depends on the type of policy you have. Term life insurance, which is designed to cover you for a specified period, typically does not allow you to cash out. This is because term life insurance does not build cash value—it simply provides a death benefit to your beneficiaries if you pass away during the term.
On the other hand, permanent life insurance policies such as whole life and universal life insurance do build cash value over time. This cash value can be accessed in several ways. Here are some options for cashing out a life insurance policy before death:
- Full withdrawal: You can withdraw your entire cash value. This option requires you to surrender your policy, meaning you will lose your coverage. You will also likely have to pay surrender charges and income taxes on the money.
- Partial withdrawal: You can choose to take out only a portion of the cash value of your life insurance policy. This option allows you to keep your coverage, although the death benefit will likely be reduced.
- Borrow against the policy: If you've had your life insurance policy for several years, you may be able to borrow money from the policy's cash value. This option usually doesn't incur taxes on the borrowed amount, but interest payments will be deducted from your cash value balance.
- Use cash value to pay premiums: You can use the money in your cash value to pay part or all of your policy premiums, making it easier to maintain your coverage.
It's important to note that cashing out your life insurance policy before death may have certain implications. For example, withdrawing funds or taking out a loan against your policy will generally reduce your death benefit. Additionally, surrendering your policy will result in the loss of your coverage. Therefore, it's crucial to carefully consider your options and understand the terms of your policy before making any decisions.
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Bankruptcy exemptions
Federal bankruptcy exemptions include:
- Motor Vehicle Exemption
- Tools of Trade Exemption
- Personal Property Exemptions (e.g., animals, clothing, appliances, books, etc.)
- Jewelry up to a certain value
- Retirement accounts
- Insurance Exemptions (e.g., unmatured life insurance policies, life insurance policies with a loan value up to a certain amount)
State exemptions vary but often include:
- Homestead Exemption (protection for residential homes)
- Motor Vehicle Exemption
It is important to note that bankruptcy exemptions have specific criteria and value limits. For example, the federal homestead exemption has a limit of $27,900, while the federal exemption for an unmatured life insurance policy is fully exempt.
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Chapter 7 and Chapter 13 bankruptcy
Chapter 7 and Chapter 13 are the two most common types of bankruptcy that individuals file for. Here's how they work and how they relate to cashing out life insurance:
Chapter 7 Bankruptcy
Often called "liquidation bankruptcy," Chapter 7 is the most common form of bankruptcy. In this case, the debtor's assets are sold off, and the proceeds are used to pay back creditors. All of a debtor's possessions, including real and personal property, cash, and other assets with monetary value, are considered the "bankruptcy estate." This estate is then liquidated to satisfy the debtor's financial obligations.
In the context of life insurance, if you have a term life insurance policy, it is unlikely to have any value until it pays out a death benefit. On the other hand, a whole life insurance policy has an investment component that accumulates cash value over time. This cash value is considered an asset and must be reported and exempted in your bankruptcy filing.
Chapter 13 Bankruptcy
Chapter 13 is similar to Chapter 11 but is designed for individuals rather than businesses. In this scenario, the debtor can keep their property while repaying debts over a period, generally three to five years, following a court-approved repayment plan.
In the context of life insurance, if you receive life insurance proceeds within 180 days of filing for Chapter 13 bankruptcy, those proceeds become part of your bankruptcy estate. If you receive the proceeds after this 180-day period, they are not part of the estate. It's important to consult with an attorney to understand your options in this situation.
Protecting Life Insurance in Bankruptcy
Whether you can protect your life insurance policy or proceeds in bankruptcy depends on several factors, including the type of policy and applicable bankruptcy exemptions.
Term life insurance policies, which have no cash value, are unlikely to be affected by bankruptcy. Whole life insurance policies, on the other hand, have a cash value component that may be at risk. You may be able to exempt a portion of the cash value from creditors, depending on your state's exemption laws and the federal exemptions.
Additionally, if you are the beneficiary of a life insurance policy and the insured dies within a certain time before or after you file for bankruptcy, the proceeds could be considered part of your bankruptcy estate. It's crucial to report these proceeds to your bankruptcy trustee and consult with an attorney to understand your options.
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Term life insurance policies
If you are considering cashing out your term life insurance policy, it is important to understand that this option is not available. However, you may have other alternatives to explore. One option is to sell your term life insurance policy to a third-party company through a life insurance settlement. Keep in mind that the buyer will take over your policy and receive the death benefit payout upon your death. Additionally, you will likely sell the policy for less than the death benefit value.
Another alternative is to adjust your term life insurance coverage. If your premiums are no longer affordable, many insurance companies are willing to work with you to lower your coverage level, resulting in lower premiums. You also have the option to convert your term life insurance policy into a permanent policy, such as whole life or universal life insurance. These permanent policies offer a death benefit and allow you to build cash value over time, which you can withdraw or borrow against. However, please note that converting to a permanent policy will result in higher premium payments.
Before making any decisions regarding your term life insurance policy, it is essential to carefully review your policy contract and consult with a trusted financial advisor or insurance professional. They can help you understand the specific terms and conditions of your policy and provide guidance based on your unique circumstances.
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Whole life insurance policies
In the context of bankruptcy, whole life insurance policies with a cash value component are subject to seizure. This means that the cash value of the policy can be used to repay creditors. However, there is a federal exemption of $13,400 to $14,875, depending on the source, meaning that any value over this amount is subject to seizure. It's important to note that state laws may provide additional exemptions, so consulting with a bankruptcy attorney is advisable.
If you can no longer afford the premiums on your whole life insurance policy due to financial difficulties, the accumulated cash value may be able to cover your premiums for a period of time. However, if the cash value is insufficient or you are unable to make payments, your policy will likely be terminated, and your beneficiaries will not receive a death benefit.
When applying for life insurance after declaring bankruptcy, insurers will consider your financial stability, including your income, assets, and credit history. They may also require you to wait for a certain period after your bankruptcy discharge, typically one to two years, before offering you a policy. The specific requirements and waiting periods may vary depending on the type of bankruptcy (Chapter 7, 11, or 13) and the individual insurer.
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Frequently asked questions
Whether you can cash out your life insurance policy before filing for bankruptcy depends on the type of policy you have. Term life insurance policies are designed to cover you for a specified period and do not usually build cash value, so you cannot cash out early. Whole life insurance policies, on the other hand, accumulate cash value over time, which you may be able to withdraw or borrow against.
Yes, you may be able to cash out your life insurance policy after filing for bankruptcy, but it will depend on several factors, including the type of policy you have and the bankruptcy exemption laws in your state. If you receive money from a life insurance policy after filing for bankruptcy, you will need to report it to your bankruptcy trustee.
If you declare Chapter 7 bankruptcy, you may be forced to surrender a portion of your life insurance policy's value to creditors as part of the debt forgiveness process. If you declare Chapter 13 bankruptcy, you will create a payment plan to repay your debts, and your life insurance policy will likely remain in place as long as you can continue to pay the premiums.