Who’s responsible for unpaid debts after you die?

At some point, we all have to come to grips with the fact that we won’t live forever. But when that day comes, who’s responsible for picking up the tab we leave behind?

Whether it’s credit card debt, medical bills or an outstanding mortgage, most people have at least some type of unpaid debt to resolve after they pass away.

Here’s what you need to know to make sure both you and your loved ones remain in good shape when your number is finally called.

Transitioning to a legal estate

After you pass away, your assets (and debts) are converted into what’s called a legal estate. This is the formal, legally binding account of your possessions, investments and liabilities.

An executor - typically a trusted family member or attorney - is then tasked with settling all unpaid debts and distributing assets based on your will or family ties through a process known as probate. This individual will be working directly with credit card issuers and lenders to settle balances, as well as writing checks from the estate. 

Federal law dictates that outstanding, unsecured debts are always paid first in probate. Meaning, if you’ve got $50,000 in assets but $10,000 in credit card debt, your family members and loved ones will only receive about $40,000 in inheritance.

On the other hand, assets with associated secured debt, such as a home or vehicle, may still be disbursed even though the asset isn’t owned in full. In general, the recipient can simply assume payment responsibility rather than paying the difference in a lump sum. 

What about negative net worth?

Unfortunately, if your individual debts exceed your assets when you die, you’re still on the hook for as much as your estate can cover. For example, if you’ve got $10,000 in savings but $25,000 in unsecured debt, lenders are allowed to recoup up to $10,000. The remaining $15,000 is written off.

The good news is that, in most states, family members are not responsible for a deceased individual’s debt.

Unless you’ve co-signed a loan or credit card application, you can rest easy knowing that you’ll never hear a knock on the door from your second cousin’s creditors, and vice-versa. Still, a negative net worth ultimately means that you won’t pass on inheritance to your heirs, and you may place an undue burden on loved ones to handle funeral expenses if arrangements aren’t made in advance.

Moreover, there’s also an exception to this rule if you’re married and live in a community property state. Residents of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin and Alaska may be liable for their spouse’s debts even if they aren’t a formal co-signer. 

Exceptions: individual debt

As a rule of thumb, if you’ve co-signed a loan or if you jointly own an asset with someone who passes away, you’ll assume full responsibility or ownership of the situation.

This means that if the deceased individual has made charges without your knowledge, damaged shared property or has gone underwater on a co-signed mortgage, your own financial standing can take a serious hit. With such serious implications, it makes it all the more important to think twice before co-signing a loan with a family member or friend.

Avoiding disaster in probate

Beyond building up retirement savings to ensure a positive net worth when you pass away, there are a number of savvy ways to simplify the probate process so that your heirs receive inheritance without obstacles.

Intentionally adding heirs to a joint bank account, for example, can make the transfer of funds seamless, as well as draw clear line to the intended recipient. Maintaining joint ownership of real estate serves a similar function, as property transfers automatically to the surviving owner(s) at the time of death.

Another way to guarantee your money goes to whom you intend is to set up payable-on-death (POD) and transfer-on-death (TOD) provisions for bank accounts and securities, respectively. These formal instructions allow you to name a specific beneficiary for funds to transfer to after you’ve passed away. And don't forget: You can always give away assets and financial gifts to loved ones while you’re living to avoid the sometimes-complicated process of probate altogether.

On the other end of the spectrum, if you’re concerned that a negative net worth may leave your loved ones in trouble once you pass on, taking out a life insurance policy can be an effective way to ensure stability and help pay for final expenses. Though life insurance plans vary widely, they can often cover outstanding debts and funeral costs so that family members aren’t burdened.

Though it’s a sober subject, understanding the probate process can help guide you to taking the right steps in retirement and estate planning. It’s the best way to make sure your bases are covered and that the legacy you leave to your loved ones is exactly as you intended. 

As always, the best way to protect yourself and your family when it comes to estate planning is to consult an attorney, estate planner and/or tax advisor.