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Life insurance payouts and bankruptcy: No easy answer

Life insurance policies might be relevant to bankruptcy cases in a number of ways and unfortunately, an easy answer about how life insurance values of payout relate to creditors isn't available. The truth is that the relationship between life insurance and bankruptcy depends heavily on state law, the individual circumstances of the bankruptcy case and the type of life insurance policy in question.

Some life insurance policy payouts are considered exempt from creditors and trustees during bankruptcy. Specifically, if a life insurance policy is set up to benefit a spouse, children or minor dependents, it might be deemed exempt. Bankruptcy laws might also apply thresholds on amounts that can be held exempt. These exemptions usually occur when a person is in the middle of a bankruptcy proceeding or reorganization and passes away. At this point, the bankruptcy can have an impact on the management of the person's estate, including life insurance payments.

A different type of situation that might arise related to life insurance policies and bankruptcy occurs when someone else passes away and the person involved in the bankruptcy is the beneficiary for a policy. A question is raised on how the person must treat this unplanned form of income.

Depending on where the person is in the bankruptcy process -- and what type of bankruptcy he or she is involved in -- the new income might need to be reported to the court of the trustee. The new income may or may not be exempt from the bankruptcy. In cases where it is exempt, the person keeps the funds. In nonexempt cases, the funds might have to be turned over the trustee to be used to satisfy debts.

Understanding bankruptcy exemptions can be difficult, and when life insurance or estate matters are involved, things get increasingly complex. Working with a bankruptcy professional who understands how the law applies to various situations can help you make the best choices during your bankruptcy.

Source: Duke Law Library, "Bankruptcy: effect of acts on insolvent on life insurance exemption," accessed Dec. 10, 2015

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