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Life Insurance: Maximum Safety from Creditors

Life insurance is purchased to protect people against a variety of financial situations. In fact, if a breadwinner dies insolvent, in many instances the proceeds of a life insurance policy are all the surviving family members may be able to depend on. An important aspect of life insurance is the exemption by law in every state of some portion of cash values and death benefits from the claims of the policyowner`s creditors. This protection given to life insurance comes from recognition long ago by state legislators of the special role life insurance plays in protecting the family unit.

State exemption laws may differ in some respects. However, there are several general points which can be made. The first is identification of transactions which do not receive protection.

If the life insurance proceeds are paid to the policyowner`s estate, rather than to a named beneficiary, the general rule treats proceeds as property, subjecting them to the claims of the deceased policyowner`s creditors, just as any property would be. Additionally, if a policy is assigned to a lender to collateralize a promise to repay, the general rule is that the lender`s security interest in the policy overrides the general state law exemption. Finally, as might be expected, the IRS can reach a policy's cash values by putting a tax lien on the policy. In some cases, the IRS can even reach the policy`s death benefits.

The next area to examine is how much is protected by state law. On this point, the states take a variety of positions. When it comes to exempting cash values, some states take the position that cash values are exempt to a specified dollar amount. Other states appear to exempt cash values to a virtually unlimited degree.

Death benefits are dealt with in their own right, with the majority of states fully protecting the death proceeds of life insurance from the claims of the policyowner`s creditors (other than the IRS). Some states even protect the death proceeds from the claims of the beneficiary`s creditors. In fact, these states not only protect life insurance, but also protect endowment and annuity contracts.

During uncertain, personal economic times, when cash flow problems are common, many individuals come to appreciate firsthand how exemption laws can shield their life insurance policy`s cash value from creditors. Knowing how your state defines the exemption laws will show you, and may very well solidify, how the policy you purchased may protect you from financial situations you never considered possible.