Life Insurance Payouts: Can You File For Bankruptcy?

Life insurance policies are often considered when filing for bankruptcy. The treatment of a life insurance policy in bankruptcy depends on the type of policy and the chapter of bankruptcy. Term life insurance policies, which have no cash value, are typically exempt from bankruptcy liquidation, while whole life insurance policies, which accumulate cash value, may be partially liquidated to pay off creditors. The federal bankruptcy exemption allows for up to $12,625 to $14,875 of the cash value of a whole life insurance policy to be exempted. However, any value above this amount may be vulnerable to creditors. The chapter of bankruptcy, such as Chapter 7 or Chapter 13, will determine the specific process and outcome. Additionally, the state of residence can impact the exemptions and protections available for life insurance proceeds. It is important to consult with a bankruptcy attorney to understand the specific implications for an individual's situation.

Life insurance money and bankruptcy

If you own a life insurance policy that has a cash value, or if you are the beneficiary of a policy and the policyholder dies, it can affect your bankruptcy filing. In this case, you may be able to claim the policy as exempt, but this depends on your state's exemption laws.

Bankruptcy Estate

Any property you own, including property rights, is considered an asset. All the property you own when you file for bankruptcy is called your bankruptcy estate. In Chapter 7 bankruptcy, the trustee can liquidate (sell) the assets in your estate and use the proceeds to pay your debts. However, exemption laws allow you to claim some of your property as exempt from liquidation. In Chapter 13 bankruptcy, your creditors are entitled to receive at least as much as they would in Chapter 7, but the trustee does not liquidate your property.

Life Insurance Policies and Bankruptcy

There are two primary ways that life insurance might come into play in bankruptcy. The first is if you own a life insurance policy that has a cash value. The second is if you are the beneficiary under a life insurance policy and the insured dies within a certain time before or after you file for bankruptcy.

Types of Life Insurance Policies

There are four basic kinds of life insurance: whole (sometimes called permanent), variable (sometimes called flexible or adjustable), term life insurance, and universal life insurance. Term life insurance policies do not have a cash value, but all other types of life insurance have a savings component.

Exemptions

Exemption laws vary depending on the state. Some states have a wildcard exemption that allows filers to protect any property they choose. Federal exemptions allow you to exempt up to $13,400 of your policy's cash value.

Proceeds from Life Insurance and Bankruptcy

If you receive life insurance proceeds within 180 days of filing for bankruptcy, those proceeds are considered part of your bankruptcy estate. If you receive life insurance proceeds more than 180 days after filing for bankruptcy, the proceeds are not part of your bankruptcy estate.

Protecting Your Interests

To protect your life insurance interests, you need to understand the type of interests you have, their values, whether they are part of your bankruptcy estate, and whether they are exempt from liquidation.

Chapter 7 bankruptcy

When it comes to life insurance, the treatment of policies and proceeds in Chapter 7 bankruptcy depends on several factors, including the type of policy and the timing of any payouts relative to the bankruptcy filing. Here's what you need to know about how life insurance is affected by Chapter 7 bankruptcy:

Life Insurance Policies:

Life insurance policies can be term or whole life policies. Term life insurance is strictly insurance, paying out a death benefit if the insured person passes away during the term of the policy. Whole life insurance, on the other hand, has an investment component and accumulates cash value over time. This cash value can be borrowed against or cashed out.

In Chapter 7 bankruptcy, both term and whole life insurance policies must be disclosed and listed as assets. Term life policies are unlikely to have any value unless a death benefit has been paid out, in which case the proceeds would be treated as cash assets. Whole life insurance policies, on the other hand, have a cash value that must be reported and can be claimed as exempt up to a certain amount. The federal exemptions, for example, allow debtors to exempt up to $12,625 of the cash value of a whole life insurance policy. Any non-exempt equity would have to be liquidated and turned over to creditors.

Life Insurance Proceeds:

The treatment of life insurance proceeds in Chapter 7 bankruptcy depends on the timing of the payout relative to the bankruptcy filing. If you receive life insurance proceeds within 180 days before or after filing for Chapter 7 bankruptcy, those proceeds are considered part of the bankruptcy estate and may be used to pay off creditors. This is known as the 180-day rule. However, if you receive life insurance proceeds more than 180 days after filing, they are not part of the bankruptcy estate and are generally protected.

It's important to note that you must disclose any anticipated or received life insurance proceeds during the bankruptcy process. Failure to do so could result in sanctions, including dismissal of the case or denial of discharge.

State-Specific Exemptions:

In addition to the federal exemptions mentioned above, each state has its own exemption laws that may offer additional protection for life insurance policies and proceeds. For example, in Pennsylvania, life insurance proceeds may be exempted if the beneficiary is the decedent's child, spouse, or dependent relative. In New Jersey, life insurance proceeds are exempt if the policy expressly prohibits them from being used to satisfy the beneficiary's creditors. Therefore, it's important to consult with a local bankruptcy lawyer to understand the specific exemptions that may apply in your state.

Chapter 11 bankruptcy

Chapter 11 is named after a section of the U.S. Bankruptcy Code. When a company files for Chapter 11 bankruptcy, the court will help reorganise its debts and assets, and in most cases, the company can continue to operate. The debtor, in this case, is called a "debtor in possession" and can generally run the business as usual.

However, in cases involving dishonesty, fraud, or gross incompetence, a court-appointed trustee will step in to run the company throughout the bankruptcy proceedings. The debtor in possession is not allowed to make certain decisions without the permission of the courts. These include the sale of assets (except inventory), starting or terminating rental agreements, and stopping or expanding business operations.

The business or individual filing for bankruptcy has the first chance to propose a reorganisation plan, which may include downsizing operations and renegotiating debts. If the debtor does not put forth a plan, the creditors may propose one instead. If the suggested path is deemed feasible and fair, the court will accept it, and the process will move forward.

The Small Business Reorganisation Act of 2019 added a new Subchapter V to Chapter 11, making bankruptcy easier for small businesses with less than $2.7 million in debt. This was later increased to $7.5 million in debt in 2020 and extended in 2022. Subchapter V provides for a private trustee to work with the small business debtor and creditors to facilitate the development of a consensual plan of reorganisation.

Chapter 13 bankruptcy

Eligibility

To be eligible for Chapter 13 bankruptcy, you must have a regular income, have filed all required tax returns for tax periods ending within four years of your bankruptcy filing, and meet other requirements set forth in the bankruptcy code. You must also have a combined total of secured and unsecured debts of less than $2,750,000 as of the date of filing for bankruptcy relief.

How it works

In a Chapter 13 bankruptcy, a bankruptcy trustee collects monthly payments from you for a period of three to five years to repay your creditors. This allows individuals to keep their assets but they must submit to a plan to repay creditors. The plan must be submitted for court approval and must provide for payments of fixed amounts to the trustee on a regular basis, typically biweekly or monthly. The trustee then distributes the funds to creditors according to the terms of the plan, which may offer creditors less than full payment on their claims.

Chapter 13 Plan and Confirmation Hearing

Unless the court grants an extension, the debtor must file a repayment plan with the petition or within 14 days after the petition is filed. There are three types of claims: priority, secured, and unsecured. Priority claims are those granted special status by bankruptcy law, such as most taxes and the costs of bankruptcy proceedings. Secured claims are those for which the creditor has the right to take back certain property if the debtor does not pay the underlying debt. Unsecured claims are generally those for which the creditor has no special rights to collect against particular property owned by the debtor.

The Chapter 13 Discharge

A Chapter 13 debtor is entitled to a discharge upon completion of all payments under the Chapter 13 plan as long as the debtor meets certain conditions. The discharge releases the debtor from all debts provided for by the plan or disallowed, with limited exceptions. Creditors provided for in full or in part under the Chapter 13 plan may no longer initiate or continue any legal or other action against the debtor to collect the discharged obligations.

The Chapter 13 Hardship Discharge

After confirmation of a plan, circumstances may arise that prevent the debtor from completing the plan. In such situations, the debtor may ask the court to grant a "hardship discharge". Generally, such a discharge is available only if the debtor's failure to complete plan payments is due to circumstances beyond their control and through no fault of their own; creditors have received at least as much as they would have received in a Chapter 7 liquidation case; and modification of the plan is not possible.

Life insurance and creditors

Protecting Your Life Insurance from Creditors

There are a few guidelines that can guarantee your loved ones get the protection you intended. Firstly, be specific when naming beneficiaries. List them by name, their relationship to you, and provide their date of birth and Social Security number if possible. Don't list your estate as a beneficiary, as this exposes the death benefit to creditors and legal proceedings.

Keep your beneficiaries updated, especially after major life events such as a divorce, marriage, or death in the family. You should also name a contingent beneficiary, who can accept the death benefit if your primary beneficiary is unable to, preventing the money from going through probate.

Types of Debt

It's important to note that not all debt will remain with your estate when you die. Federal student loans and some private student loans are forgiven when you pass away. However, most private loans can be recouped from your assets. Any debt that was co-signed or in a shared account becomes the responsibility of the people you leave behind.

Community Property States

If you live in a community property state, your spouse will be responsible for any debts you took on during the marriage, even if they didn't co-sign the loan. These states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

Protecting Beneficiaries from Their Own Debts

While regulations protect your beneficiaries from your creditors, there are no regulations that shield your beneficiaries from their own debts. Once they receive the death benefit, it becomes part of their assets, which creditors can seize if they are past due on their loans. To eliminate this risk, you can set up your life insurance policy to include a spendthrift clause. This allows the insurance company to hold the death benefit proceeds in a trust and pay your beneficiary in installments instead of a lump sum, protecting the money from creditors. Alternatively, you can name a trust as the beneficiary of your life insurance policy.

Frequently asked questions