If you've got debt and die tomorrow, don't assume it will disappear. Chances are, it will eat into the assets you may be planning to leave your heirs and may even wipe out your estate.
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Estate and financial planners say it's an increasingly common scenario, largely because older Americans are taking on and carrying more debt. In fact, middle-income Americans age 50 and older are now carrying more credit card debt on average than younger people, according to a report released in January by Demos, a New York-based policy research organization. That's a reversal of the firm's findings from 2008. According to the report, older households carried an average credit card balance of $8,278 in 2012, compared with $6,258 for those under 50. That doesn't include underwater mortgages, home equity lines, auto loans and other liabilities they may be carrying.
"It's not just that people have more debt than they did before, it's also that the value of their assets to pay off the debt has declined significantly," said Georgia Loukas Demeros, a tax and estate planning attorney in Chicago. "The house they bought 10 years ago may be upside down, and their investments aren't worth as much."
If your debts outweigh your assets when you die -- in other words, if you're insolvent -- the good news is that creditors can't go after your survivors for the money, as long as the debt was yours alone. (The question of who owns debt is more complicated in the 10 community property states, however.) Generally speaking, though, your survivors won't inherit your debt.
But if you do have enough in your estate to cover your liabilities, you can bet that creditors will be knocking at the door. The law requires your executor to sell your assets and pay off any debts before making distributions to your heirs. But some assets are protected from creditors, either because of specific laws that shield them or because they have direct beneficiaries and don't go through probate. Assets that don't go through probate are harder for creditors to access.
As part of an overall estate planning strategy, you can take steps to protect your assets and maximize the wealth you pass on. If you already have debt, you have to be especially careful because federal law prohibits the transferring of assets to protected accounts specifically to avoid creditors. Your best bet is to work with a qualified estate planner, because laws are complicated and vary by state. But here are a few steps to consider:
1. Be honest with your heirs
Too often, heirs are in the dark about loved ones' debts and get a rude awakening when they die. "We've seen situations where the kids were living above their means waiting for a parent to die to bail them out only to find that it won't happen because the parents have debt," said Martin Shenkman, an estate planner in Paramus, N.J. "In really bad situations, the disappointment has led to pretty significant antagonism among the heirs."
The solution, he and other experts say, is to share your complete financial picture with your successors, and update it often. You may want to give them a list of your assets and liabilities, as well as the names of any beneficiaries. Given your specific family dynamics, you can choose to reveal more -- or less -- information (such as account numbers, passwords, etc.) to your heirs as you deem appropriate.
2. Buy enough life insurance
While the main reason to buy life insurance is income protection, it can also help heirs pay off a debt on inherited items, such as a mortgage or car, that they want to keep. Typically, a loan collateralized by an asset stays with the asset, meaning someone who inherits your car or house will likely get the mortgage or auto loan as well. (If you have a lot of debt, however, your executor may have to sell off those items to pay it.)
Life insurance is almost always exempt from creditors, although the exemption amount varies by state. "Some states set a dollar limit, some exempt enough to cover the reasonable needs of dependents and some exempt all of it," said Gideon Rothschild, an estate and trusts attorney in New York City who created a state-by-state chart of exemptions. "If you have creditors while you're alive, you can't get the cash value. But once you die, the money can pass to your spouse and children and creditors can't reach it."
3. Name a person, not your estate, as beneficiary
Like life insurance, 401(k) accounts and the family home are shielded from creditors in some states. Other assets, including IRAs and payable-on-death bank and brokerage accounts, can also be difficult for creditors to reach because they have direct beneficiaries and don't go through probate.
The key to protecting those types of direct-beneficiary assets from creditors, experts say, is to specifically name an individual as the beneficiary, not your estate. "The worst thing you can do is name your estate as a beneficiary, but unfortunately I see people doing it all the time," Demeros said. "Anything you can keep out of probate is going to be harder for unsecured creditors to grab. But if you name your estate the beneficiary, that asset becomes part of the probate estate."
It's also a good idea to review your beneficiaries frequently, at least once a year, and to name a contingent beneficiary in case something happens to your first choice, said Stephen Silverberg, an estate planning lawyer in Roslyn, N.Y. "And if there's a box on the beneficiary form that says 'per stripes,' make sure you check it," he said. Meaning "of the body," in Latin, checking that box ensures that the benefits pass to the lineal descendants of your beneficiary if he or she dies before you do.
4. Consider loan protection insurance
If life insurance isn't an option for you, either because you're older and it's too expensive or you have health issues, you may want to look at so-called loan protection insurance or payment protection insurance, said Howard Dvorkin, founder of Consolidated Credit Counseling in Fort Lauderdale, Fla., and author of "Credit Hell: How to Dig Out of Debt."
These declining-term policies pay off specific loans -- your auto loan, credit card balance or your mortgage -- if you die or become disabled and unable to pay. Because they are declining-term policies, their value decreases as you pay off the loan. They are also more expensive than traditional life insurance.
"If you look at the level of coverage compared to traditional life insurance, you get a lot less bang for your buck with these," Dvorkin said. "If you take out a premium to cover a $30,000 car, you may be paying $20 a month, when you can get $300,000 in life insurance for only $300 a month." But if all you need is to cover a specific debt, then $20 a month is certainly a more affordable option. He recommends reading the fine print to make sure the policy covers disability and accidental death.
Loan protection plans that pay off your mortgage, also called mortgage life insurance, are often offered by your lender when you get a mortgage and can be a sensible choice for some people, said John H. Langbein, a professor of trust law at Yale Law School. He notes that you can shop around by asking other insurers about their declining-term policies. Just make sure you use an insurer that's reputable.
5. Start paying down your debt
The biggest gift you can give your heirs, of course, is to take care of your debt now, while you're alive. Figure out how much total debt you have, and create a plan to cut your spending and start paying it down. Then cut back on major purchases and stop using plastic. If necessary, you can get help from a nonprofit credit counseling agency.
"My favorite saying about estate planning is that it's not merely about the transmission of wealth, but about the transmission of values," said Shenkman. "The most useful asset you can pass on to heirs is not a few extra dollars, but rather the value or character trait of fiscal responsibility."