Most of us have some sort of vague idea about what happens to our assets when we die. The stuff we own gets passed on to the people we specify — assuming we've jumped through the right hoops. But what happens to our debts when we die? That's what Matt wants to know. He wrote recently looking for clarification:
My parents are both in their sixites, and don't have the best financial position. They have a significant amount of debt. I don't know exact amounts, but I wouldn't be surprised to hear they owe more money than they have in assets. Because their health is rather frail, I'm curious what could happen if they die and the liabilities (credit cards, mortgage, home equity line of credit) are greater than their assets (home, 401(k)s, life insurance). Do my sister and I get stuck with their remaining debt?
The short answer is no, Matt and his sister won't be responsible for his parent's debts. But that short answer isn't very informative. Obviously, this isn't really my area of expertise. For a bit more information, I contacted David Carlson, a local lawyer who specializes in estate planning. (Carlson is my lawyer.) Everything in the next section is Carlson's response to Matt's question.
Probate: Boring but important
What happens to your stuff when you die? The short answer is: It depends. The longer answer is: It depends on what the debts are and what the assets are. Consider the following scenario:
- Mom and Dad have two kids.
- They own a house worth $250,000 and have a mortgage on it for about $100,000.
- They own two cars that they owe about what they're worth.
- Dad has a 401(k) account containing $100,000.
- Mom and Dad have credit card debit of about $7500.
Now assume that Mom and Dad are taking their first ever trip to Hawaii and the plane crashes. Both die simultaneously. Now what?
A probate is opened. Mom and Dad's estate consists of their house, their personal stuff, and their two cars. It does not (usually) include the 401(k) (more on this in a moment). The mortgage company and the credit cards want to get paid. So do the people who loaned money on the cars. What to do? The easiest scenario is to sell the cars and pay off their debt. Then, sell the house and pay off the mortgage and the credit cards with the proceeds. Anything left over goes to the heirs.
Notice I didn't say anything about the 401(k). That's because retirement accounts (including IRAs, 401(k)s, 403(b)s, public employee retirement accounts, defined benefit plans, etc.) are usually governed by the contract that created them. In that contract, the owner of the account will have specified beneficiaries. Usually people name their spouse (you're required to under ERISA), and then their children as alternate beneficiaries. In our scenario, if Dad did that, then the funds in the 401(k) go directly to the children and do not go through probate. That means they're not subject to the claims of creditors.
But if we change the original scenario so that the house is worth only $200,000 and the mortgage is $250,000 (meaning that the house is upside down), then there's not enough money in the estate to pay off the mortgage. Do the heirs have to pay this out of pocket? Absolutely not. The creditors of the estate can only get what's in the estate. That's it.
What if Dad screwed up and didn't name a beneficiary for his 401(k) other than his now-dead wife? Then the money might go into the estate and be subject to creditor's claims. It would depend on what the initial contract said. Sometimes the contracts say that the money goes to the children of the account holder. Other times they say that the money will go to the estate if there's no named beneficiary. The bottom line is that you want to make sure your beneficiary designations are current.
A final note
Carlson also notes that there are tax consequences to beneficiaries who receive funds from retirement accounts. If you're in a situation where you need more detailed information, contact your attorney or accountant. Your estate plan is nothing to mess around with; a lot of people ignore it until it's too late, and many others make a mess of it because they haven't stuck to legal guidelines.
That reminds me: Kris told me that if I didn't complete my “death list” for her by the time she got home from work today, she might actually kill me. She's joking of course, but all the same: I'd better step away from the keyboard and finally compile this information for her!