How Bankruptcy Can Affect Your Life Insurance Options -

How Bankruptcy Can Affect Your Life Insurance Options

Filing for personal bankruptcy can represent a nightmare scenario, but when it comes to protecting your assets, a life insurance policy could provide you some protection beyond its death benefit. But first, it’s important to understand the relationship between bankruptcy and your life insurance policy.

Life insurance is considered “valuable property” which means creditors may attempt to “acquire an interest in the policy’s values.” But all states and the federal government have “enacted legislation providing protections for life insurance against the claims of creditors,” says Glenn E. Stevick, Jr., a professor at The American College.

There are two types of bankruptcy for individuals: Chapter 7 and Chapter 13.

Chapter 13 allows you to hold onto your assets and doesn’t put you at risk of losing property, but you must repay some of the debt over a three to five year period. If your cash value for life insurance is worth more than the exemption in your state, then consider filing Chapter 13 to protect your assets.

If you pass a means test and can file a Chapter 7 you must liquidate your possessions and assets, and that typically takes four months.

It also means your life insurance policy could be affected.

One of the worst things you can do is liquidate your assets and start borrowing money from your life insurance and retirement funds, rather than filing bankruptcy.

“People start taking whatever little money they have to see if they could get out of debt by re-paying it,” Cho says. “I see people drain their $40,000 retirement fund for $100,000 in credit card debt. They start selling their cars and homes without an exit strategy. The game plan is to keep as much as possible.”

When filing for bankruptcy, make sure you disclose everything including the current, accurate cash value of your whole life insurance policy. Some people don’t “because they are afraid to and end up losing it because they failed to disclose it’s true value,” says David Leibowitz, a bankruptcy lawyer for Lakelaw in Chicago, Ill.

Under state and federal bankruptcy law, an individual filing for bankruptcy may elect exemptions under federal or state law, but not both. Explains Stevick, 34 states like Illinois, New York, California and Florida have “opted out” of the federal law and have inducted their own state protections.

Sixteen “choice states” – including Texas – allow debtors to choose between federal and state exemptions. Under federal exemptions, one can protect up to $10,775 of a life insurance policy’s cash value (doubled for married couples). In some states, the unused portion of the homestead exemption (real and personal property) may be used for other property, including the cash value of a life insurance policy. Some states require the policy to be in force for one to two years for protection under a state exemption, to prevent using life insurance as a shelter in bankruptcy planning.

In order to be eligible to file bankruptcy under state protections, you must be considered a resident and live in a state for 24 months.

In Illinois, whole life insurance is exempted from creditors to the extent that it is necessary to support a dependent (a spouse and dependent children), but the legal interpretation is up to your bankruptcy judge.

When you file your bankruptcy petition you’ll typically include a schedule or list of your exempt property, which can include your life insurance policy.

Ron Caruthers, a financial planner, who helps individuals pay for college with overfunded life insurance policies, says Florida, is the most debtor-friendly state to file bankruptcy since it has a strong homestead exemption. Another debtor-friendly state is Texas, which allows large exemptions for cattle and homesteads.

“It’s why O.J. Simpson took all his assets and moved to Florida and put them into life insurance and a home, since they couldn’t touch either when he filed for bankruptcy,” Caruthers says.

On the opposite end of the spectrum is Arizona which Caruthers says “is the most creditor-friendly state.”

Keep in mind that all 50 states are different when it comes to bankruptcy protections, so it’s best to contact a financial planner or bankruptcy lawyer in that state to learn more.

Photo - “US BANKRUPTCY COURT” by Fried Dough is licensed under CC BY 2.0

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