Dying with Debt

Up to this point, Plainly Legal has focused on topics dealing with the transfer of wealth, either through lifetime gifts or at death. Today's blog takes a detour to discuss the question of what happens with a person's debt when they die. Recently, a friend contacted me with a question about information she received from someone at her bank when she attempted to designate beneficiaries for her bank accounts. This bank employee (I did not ask which bank or the job title of the employee) told her that she should not designate a beneficiary because, if she were to die with debt that debt would then pass to her loved ones. Before continuing with today’s blog, it is important to emphasize:

THAT STATEMENT IS SIMPLY NOT TRUE.

The good news is that personal debt is non-inheritable. If a person incurs debt during their lifetime, the beneficiaries of the person’s estate, no matter if they are beneficiaries through a Will, Trust, or the Intestacy Statutes, are not personally liable for any debt left behind. This does not however mean that debt disappears at death.

When a person with personal debt dies, that person's debt becomes the liability of the person's estate. Creditors are then free to try to collect on that debt from the estate. It is the responsibility of the Personal Representative (and Trustee) to pay the enforceable debts of the deceased prior to making distributions to the beneficiaries. To ensure that creditors receive payment prior to making distributions beneficiaries, the Michigan Probate Code mandates that the personal representative of the estate is required to publish a death notice (to inform unknown creditors) and provide notice to known creditors. Those creditors then have four months to present their claims to the Personal Representative. After the four-month window, with some exceptions, the probate statute bars creditors’ claims against the estate.

When a creditor makes a claim against an estate it is the responsibility of the personal representative to determine if the claim is valid and, if so, to provide payment to the creditor. While the personal representative is responsible for making these decisions, they do so in a fiduciary capacity and upon determining that a claim is valid, pay the claim with the estate's assets. Absent extraordinary circumstances, the personal representative is never personally liable to pay the debts of the estate they represent. The practical result of this situation is that a personal representative may determine that a creditor’s claim is valid, but the estate lacks the assets to pay the debt. In that situation, neither the personal representative nor any beneficiaries of the estate become personally liable for the unpaid debt.

At this point, it is important to address a number of minor exceptions to these rules, the largest of which being that the four-month claim window becomes a three-year window if the Personal Representative fails to properly publish notice of the death or fails to inform a known creditor of the death (a "known creditor" is a creditor that's existence is known or reasonably discoverable by the personal representative). A second common exception is that the four-month claim window does not apply to any form of secured debt, such as a lien or mortgage. In almost every circumstance, the holder of a secured debt has the right to enforce their security agreement and take possession of the property in which they have a security interest. For example, a bank may repossess a house that is subject to a mortgage owned by the bank if the estate is unable to make payments on the bank’s loan.

Since probate law requires that creditors receive payment prior to distributions to almost all beneficiaries (there are exceptions for a limited number of distributions to a surviving spouse and minor children), it is possible that the estate assets can be exhausted before a beneficiary receives anything from the estate. In the event that the debts of an estate exceed the estate assets the beneficiaries receive nothing, however those beneficiaries do not incur liability for unpaid debt because of their status as beneficiaries.

While it is the responsibility of the estate to pay the deceased's debts prior to making distributions there are certain assets that are never accessible to the creditors of the estate, including retirement benefits and life insurance proceeds. While creditors cannot attach the assets of a person’s IRA in order to recover debt, once a person receives a distribution from the IRA, creditors can attempt to recover those funds if the person deposits them in a bank or other financial institution. When the owner of an IRA dies with debt the distributions to the beneficiaries of an inherited IRA are protected from the original owner’s creditors. This is true even if the IRA beneficiary is a Trust or the estate.

 We now reach the situation my friend encountered on her trip to the bank. Unlike IRA accounts, beneficiary designations on bank or investment accounts do not enjoy the same protection from the original owner’s creditors. While a beneficiary designation causes those accounts to pass directly to the individual named in the designation, such designations do not limit the rights of creditors of the previous owner. This does not mean that someone named as the beneficiary of a bank account becomes liable for the original owner’s debts. In practical terms this means that a creditor can recover assets in a bank or investment account transferred via beneficiary designation, but that creditor still may not recover in excess of the assets transferred from the deceased individual.

Substantial debt is an understandable concern for many people these days. It is important to remember that when you or your loved ones die, personal debt generally becomes the responsibility of the deceased person’s estate, for the Personal Representative to pay before making distributions to other beneficiaries. Payment of these debts can consume the assets of an estate, but in that circumstance the beneficiaries are not liable for debt in excess of the estate’s assets.

 It is just as important to consult reputable source when dealing with debt as it is when making decisions regarding other planning. While employees of financial institutions may seem like knowledgeable sources of information, you should be aware that not every employee receives the same training. If you have doubts as to the accuracy of information you receive, ask to speak with a manager, contact your attorney for a second opinion, or send us a message and we will attempt to address your issue, directly or in an upcoming blog.