The loss of a family member is already one of life’s most difficult experiences. Unfortunately, in addition to mourning the loss of a loved one in the following weeks and months, this stressful period may also include uncomfortable discussions about money, which can strain family relationships during an already difficult time. These conversations become even more challenging if the deceased had unpaid debts, leaving the surviving spouse and/or executor with a number of complicated obstacles to overcome when handling the estate to satisfy creditors.
As a general rule, the estate of the decedent is required to pay the debt obligations. When the estate is not large enough to cover the debts, the responsibility to pay the remaining debt balance can fall to the surviving spouse. The level of debt transferred will include factors such as the specific state of residence of the deceased and the probate laws of that state. Key considerations include: whether or not the state is a community property state; whether or not the debt was acquired jointly or individually; and whether the property was acquired before or during marriage.
Currently, community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin and Alaska (in certain circumstances). In these states, surviving spouses will inherit the debts of the deceased that occurred while they were married, even if their name is not on the account. This is not the case if the debt was incurred before marriage, such as student loans. This same principle applies for property owned, income acquired and gifts received prior to marriage. Creditors can only go after assets in these states to settle unpaid debts of the deceased if income and property were gathered during marriage and the debts owed were acquired jointly. Financial advisors representing clients in community property states should work to determine what debt obligations exist and how to avoid this scenario. In non-community property states, the surviving spouse has no liability to anything his or her name is not on.
When both parties pass, the estate of the second death will be used to pay off any remaining debts and, in any state, the debt itself is not passed on to family members.
However, family members are obligated to sell assets acquired in the estate to generate income to pay off the deceased’s debt, which can leave the survivors with no income stream. Estate benefits won’t be transferred to those intended unless the benefiter absorbs the debts and uses the received assets to pay off the decedents outstanding balances. Additionally, a common mistake is thinking that placing assets in a joint name, making them “payable-on-death” or naming a beneficiary will protect the assets from creditors. This is not the case, and creditors can claim assets distributed in a will as collateral to pay off debts of the deceased.
In all cases, the executor, or “personal representative,” is responsible for getting the deceased’s assets through the probate process and then either properly funding the trust of the deceased, or distributing the assets, based on the desires of the will.
Most importantly, when handling unpaid debt, the executor will need to publish a notice of decease to the creditors in order to arrange for payment or file a claim.
As with most financial situations, the best approach is to be prepared and to plan ahead. Financial advisors should work with their clients to prepare an insurance needs analysis, which can help ensure a married couple has protection against acquiring a significant debt obligation. This is set up with the calculation that when one spouse passes away, all liabilities (including mortgages) will be paid off. This is the easiest way to plan for the potential debt balance at time of death. The most common way, and the most recommended, is to set up a life insurance plan for each person. Incurring benefits from a life insurance policy is the easiest and most appropriate way to protect the estate from excessive amounts of debt.
Unfortunately, dealing with end-of-life issues in families is part of the job for a financial professional, but it’s also another example of why clients should be treated like family. Being highly-involved in the lives of clients will allow the creation of an estate plan that will help the family navigate an extremely difficult time. After all, the focus should be on celebrating the life of a loved one after they are gone, not worrying about how to pay off their debts.
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