What happens to your debt when you die?

Although the probate process is defined by state laws, and thus varies greatly depending on where you live, there are a few commonalities that exist. These commonalities include the order by which your estate is paid out. Let's go back to Pappy's pocket watch. If your bank accounts and other assets cannot fully cover the debt you owe, is the pocket watch Pappy promised your grandson in jeopardy of being lost to a bank? Unfortunately, as part of the estate, family heirlooms are not safe from debt collectors. But that doesn't mean debts are paid out first. The probate process settles the estate in a responsible order, starting with funeral costs.

They say you can't take it with you when you die, but they failed to mention just how expensive dying can be. Not only are there funeral expenses to pay, there are lawyer and other administrative fees involved in settling an estate. The probate process assures all of these expenses are paid out first, so your family is not left with a stack of bills in your absence. If there is any money left over, we move on to step two: family allowances. Family allowances can be paid to the surviving spouse and/or minor children and are -- you guessed it -- defined by state laws. These can range from a do-not-exceed amount, such as Kansas's cap of $25,000 to an open-ended amount that takes into account the family's need and provides enough money for one year, as is the case in Texas [source: Kansas Bar Association, Texas Legal Services Center]. After family allowances, we move on to debt. And again, here's the kicker -- only after all debts have been paid do we move on to division of the estate to surviving family according to a will, or in its absence, state law. If the estate's value cannot pay out all of the debts, anything with value that was bequeathed in the will must be sold to cover the debt.

Now that we understand what commonalities exist, let's discuss the exceptions. We know how an estate is settled, allowing some money for expenses and surviving family before paying out debt, but what about life insurance policies and 401ks? How are mortgages handled? We'll discuss these and other issues that muddy the waters on the next page.

Now that we understand the probate process and the fact that many intricacies are state-defined, it's time to dive into some of the exceptions to the rule. As we discussed, loans that are cosigned are the responsibility of both parties, while debt in your name alone cannot be passed on to your surviving family. This is the case most of the time, but not in Alaska, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin [source: Pond]. These states wanted to be different, so they all passed laws stating any property acquired during a marriage, whether in one spouse's name or both, is common property. This gets a bit messy when settling a divorce, but that's another day's question. In regards to settling an estate, common property laws simply assert that your debt, if acquired during marriage, will be passed on to your spouse after your death. If that doesn't sound like something you want to deal with, there are 41 other states you might want to consider moving to.

Another exception lies in debts associated with physical property. If you bequeath your home to your son, the debt you still owe on the mortgage will be given to him with the property. This is true for all property, including cars, boats and jewelry. The good news is this exception only exists if the property is worth more than the debt owed. If you are upside down on your home mortgage and owe more than the property is worth, this debt will be settled by your estate or forgiven by the bank depending on how much is left in the estate. So, even though a family member assumes your debt after your death, they really assume possession of a piece of property. If the family member cannot afford the loan payments, he or she may sell the property and keep the difference in monetary value.

Finally, let's talk beneficiaries. If you hold a life insurance policy, pension plan, 401k, or the like, you're probably familiar with this word. These plans require that you name a beneficiary, or a person to whom the value of the plan is given upon your death. Many people purchase life insurance policies to assure their families are taken care of financially when they die. Ready for a deep sigh of relief? This money is not considered part of the estate, and thus cannot and will not be used to pay off your debts after death. Phew! All in all, debt after death is a pretty reasonable process. Just don't forget to plan for it by investigating the intricacies of your state's laws.