Understanding how debt impacts Life Insurance payouts

If you have life insurance, you’ve probably wondered about what would happen to your debt if your policy beneficiary obtains a life insurance payout. Whether it’s credit card debt, mortgage or some other personal debt, you’ll want to know what the implications are for your debt – and your beneficiaries – for planning purposes.

Life insurance and debt

Your deceased estate executor is obligated to pay off your debts before the remaining proceeds are paid to beneficiaries. This might involve selling assets for debt repayment. If there are insufficient funds and assets, your deceased estate could be bankrupted.

However, your beneficiaries will receive your life insurance payout even if you have outstanding debt or if your deceased estate is bankrupt. The payout from a life insurance policy is payable to the named beneficiaries on the policy. So, unless you have failed to nominate any beneficiaries, life insurance proceeds are generally protected from your estate debts.

The same principle generally applies to other proceeds which may be paid directly to beneficiaries without being processed by your estate, such as superannuation benefits.

Beneficiaries’ obligations

Beneficiaries of life insurance policies are usually not required to pay any debts owed by the deceased estate, whether it’s secured or unsecured debt.

However, you should be aware that the obligation to pay your funeral costs will generally rest with your next of kin, not with your estate. So that’s why it is generally a good reason to nominate as a beneficiary the person you expect will need to pay for these costs.

When can you use a life insurance payout to pay debt?

Although it isn’t compulsory, you can use your life insurance payout to pay outstanding debt if you wish to. If you want to have this done in the event of your death, you need to provide for it in your estate planning. You can update your Will to give your executor the authority to use your life insurance policy payouts to cover certain types of debts.

Paying off your home mortgage can be a good strategy if you’re leaving your house to your spouse or other financial dependents without fear of them needing to liquidate the asset to meet your debts. In this way, life insurance can be an excellent tool for your estate planning strategy, allowing you to provide extra security to your beneficiaries.

Leveraging the benefits of life insurance in estate planning

Having life insurance is crucial for managing the uncertainties of life, but how you hold your life insurance is as critical. You’ll want your policy to benefit the right people, while minimising taxes and other claims on the proceeds.

Holding the policy in own name

If the policy is held in your name, the proceeds will go to your estate in the event of your death, unless you have nominated beneficiaries. You might have reasons to want your payout to be managed under your will.

It’s important to list who you’d want to receive the proceeds, as if you don’t and the payout goes to your estate, the payout could be used to pay your outstanding debts, thereby reducing the amount paid to your beneficiaries.

However, if you’re certain you’ll have no debt and want to better manage how your life insurance policy is to be paid out to your beneficiaries, you may direct the payout to your estate. You could also choose to hold the life insurance policy in a special structure such as a trust, but you should seek expert advice about how to structure this appropriately to meet your goals.

This may offer more protection while allowing you to dictate gradual payments rather than a lump sum to younger beneficiaries.

Nominate beneficiaries

You can arrange your life insurance policy so the payouts go straight to your beneficiaries and bypass your deceased estate. For example, if your child is nominated as a beneficiary under your life insurance, he or she will receive the proceeds directly without it first passing through your estate. If he or she is a minor, they will generally receive the proceeds on trust, which means the funds will generally only become available to them upon attaining the age of 21. In this manner, your payout won’t be used to pay your debts unless your beneficiary decides to offer the payouts they’ve received to do so. This is usually true even if your estate is declared bankrupt.

Life insurance through super

If you have a life insurance policy through your super, you might be more limited in your options. Generally, you can only nominate your estate or a dependent (as defined under super laws) to be your beneficiary. In addition, you need to make sure your nomination is a valid one; otherwise the superfund trustee could overrule your nomination. If you don’t make a nomination the trustee will determine who ought to receive your proceeds, and this can sometimes lead to unexpected outcomes. If you nominate your estate, the payout could be used to pay any outstanding debt.

Life insurance is an excellent way to protect your partner, family, and dependents against life’s unexpected events. Having the right level of insurance is vital, but so is ensuring you’ve considered how it works in accordance with your estate planning, ideally with the right legal advisors. By doing so, your beneficiaries will receive your intended payouts when and how you prefer.

Real Insurance can help protect your family against the devastating financial impact of death or disability. With our award-winning life insurance policies and friendly customer service team, we’re ready to help you out with finding the right policy to suit your requirements. Contact us today for more information, or get a quick quote now.