By Dawn Reiss, Life Quotes, Inc.
Filing for bankruptcy is usually person's worst nightmare, but when it comes to protecting your assets (including the value of your life insurance policy), information is key.
A life insurance policy 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 with The American College.
Here's some basics you should know when it comes to bankruptcy and how it affects your life insurance policy.
First, more people file for bankruptcy than you might imagine. With the latest economic downturn and mounting bills, the current bankruptcy-filing rate is at a 5-year high, according to recent data released by Automated Access to Court Electronic Records (AACER). What's more, the American Journal of Medicine reported that more than 1.5 million people filed bankruptcy last year, 60 percent of those filings were the direct result of medical bills.
The American Journal of Medicine, for example, found that 1 in 25 people in the Bay Area have filed for bankruptcy last year, says bankruptcy attorney, Jeena Cho of San Francisco-based JC Law Group.
"It's like the dirty little secret," Cho says. "Two things that we don't talk about are death and money. When people start talking about their financial issues, they find there are plenty of people in the same boat."
There are two types of bankruptcy for individuals: Chapter 7 and Chapter 13.
Chapter 13 is where you can hold on to your assets and aren't at risk for 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, Cho recommends.
If you pass a means test and can file a Chapter 7, you must liquidate your possessions and assets, which typically takes four months. It also means your life insurance policy could be affected.
Cho says one of the worst things someone can do is liquidate their assets and start borrowing money from their life insurance and retirement funds, which are almost always protected in 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."
Also, 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). Also, in some states the unused portion of the homestead exemption (real and personal property) may be used for other property, including the cash value from 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 over funded 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