When a person dies and a life insurance benefit is paid, a question that often arises is, “Can a creditor, such as the IRS, seize that money to pay a debt?” The answer to this question depends on two factors: the beneficiary and the owner of the policy.
First, let us consider the situation of a person who dies while owing the IRS money. If a beneficiary is named on the policy, and the insured is not the owner, the IRS cannot take the money from the insurance policy proceeds. This is because the owner of the policy provides the coverage for the beneficiary, and the insured’s death is only the qualifying event that causes the money to be paid. In other words, the money never passed through the insured’s estate, so it is not really part of the money “owned” by the deceased person. Other assets, such as property and bank accounts, can be seized by the IRS in this situation, but the life insurance proceeds will pass intact to the beneficiary.
On the other hand, if the owner of the policy and the insured are the same, then the situation changes. Now, the proceeds of the life insurance policy must pass through the estate of the deceased person before reaching the beneficiary. If the deceased person owes money to the IRS, then that agency can legally file a lien on the estate and take the money prior to it being distributed by the probate court to the heirs. In this case, the IRS would definitely be able to take any funds that are added to the state by a life insurance policy. However, there are some exceptions to this rule, such as group life insurance offered by employers, which is generally exempt from being included in an estate.
In order to clarify if your policy falls under this rule, you must talk to your agent and review your policy.
Finally, if the beneficiary owes the IRS, and receives life insurance proceeds, then the IRS can seize those proceeds just as it can any other assets owned by the debtor. The only way to prevent this is to have the money placed in a trust for the benefit of the beneficiary. If you have adult children, for example, who have extreme debts, it may be wise to place the proceeds of life insurance in a trust rather than give them directly to these people. This will help protect the beneficiary’s assets from seizure not only by the IRS, but by other creditors as well.
If no beneficiary is named, the IRS is free to seize any life insurance benefits prior to them being distributed to the next of kin as part of the deceased person’s estate. The rule which applies here is the same as the rule governing ownership of the policy; if money enters the deceased person’s estate, it can be levied prior to being distributed.
A creditor should never be named as the beneficiary of a policy. Although many creditors attempt to have you name them as beneficiaries to “secure your debt,” the fact is that you do not have to do this. You can name a family member as beneficiary, and the creditors will have to petition the estate for payment of the debt. While many people think it is “right” to name creditors, this often leads to money being siphoned from your estate which your heirs need to pay costs. You can also put all life insurance proceeds into a trust, which will protect the funds from all creditors and allow the trustee to make the decisions about who is paid.
Taking out loans on life insurance policies also opens you to problems when the time comes to pay the benefits. Typically, loans against life insurance are made at extremely high interest rates, especially considering that the loan is secured by collateral. It is far better to borrow your money from a cheaper source, such as a bank, and leave your life insurance proceeds to those who will survive you. Life insurance companies are eager to make loans to policyholders, knowing they have a secured debt and control over the payback, but these loans are generally not good value for your estate’s money. Instead, talk to your financial advisor about other options, including liquidating other assets, before you borrow against your policy. It may be possible to use your life insurance as collateral against a loan with a much lower interest rate, which you can pay back prior to your death, leaving your insurance proceeds free for your heirs.