by Richard F. O’Boyle, Jr., LUTCF, MBA
Divorce is never easy. It is an emotionally taxing experience, but may be an opportunity for a new beginning. There are so many minor details that need to be ironed out between the two parties that some are bound to get overlooked. Life insurance is an important aspect that many people might not think about until it’s too late.
Divorce Decree
When you purchase life insurance, the goal is to make sure your family is provided for in the event of your death. It’s important that the life insurance is addressed in the divorce decree and the proper language associated with it.
You and your soon to be ex-spouse need to come to an agreement on what you plan to do and what your options are. The odds are your spouse is the beneficiary of the money. While you most certainly make changes to your will after a divorce, remember that beneficiaries on a life insurance policy can only be changed by filing a new beneficiary with the insurance company.
In many cases, the divorce decree will spell out one partner’s financial obligations to the couple’s children. These may include a requirement to provide financial child support, health insurance coverage, college funding or assistance of other sorts until the children reach a certain age. Just as with a married couple, life insurance would provide a ready financial asset in the event that the individual dies prematurely. Some planners would calculate the value of these obligations and obtain a term life insurance plan (or repurpose an existing plan) that would cover this amount.
As married couple accumulate assets over time, at the time of divorce those assets are usually split up. The cash values in a permanent life insurance contract are assets just as a house, retirement plan or ownership in a business. Keep in mind that permanent life insurance has very specific tax rules associated with it – which can be a curse and a blessing.
Transfer of Value and Taxation
When you transfer the value of your life insurance to another party, the government says that the death benefit is now taxable. This is called the “transfer for value” rule. Life insurance death benefits are generally federally tax free, but people were taking advantage of this by continuously transferring the policy and reaping the benefits.
The rule has been adjusted so that divorcing parties are not subject to the transfer for value rule: The recipient spouse will have a cost basis in the policy equal to the net premiums paid by the transferor spouse. So while the death benefit might not be fully tax free, it will depend on how much in premiums were spent over the previous years. It’s wise to speak with your attorney about the specifics of your case and relevant state laws (which may vary considerably).
If the divorcing partners have significant assets, including the value of life insurance death benefits, they may be subject to federal and state estate taxes. This can be extraordinarily complicated and is not the subject of this article.
It’s a good idea to keep a policy in force until all of the details have been worked out: don’t jump the gun and cancel a policy to buy a new one. You may not be getting the best rate and in some cases may even be uninsurable. For this reason, make sure that you have a good grip on exactly what coverage you have, and what coverage you will need.
Designating Beneficiaries
If children are involved, you should carefully consider whom to name as the new beneficiary. Minor children who receive life insurance proceeds may wind up with the ex-spouse as their guardian – and controller of the inheritance. This may not be in synch with your wishes.
It’s not uncommon to place a life insurance policy into an irrevocable life insurance trust so that you can spell out how the death benefit will be paid out after you die. A trust is an entity that is managed by a person or group of people to manage the trust’s assets according to the guidelines spelled out in the trust’s founding documents. For example, if your children are very young and can’t handle suddenly having several hundred thousand dollars, you can make the trust the beneficiary. The trustees would ensure that the children get enough money for college, health or even vacations. The children or your ex-spouse can’t touch the money without the trustees’ approval.
You should also address the possibility of a future spouse and their claim to the insurance. If children are not involved, you can negotiate taking your current spouse off and either canceling the policy or changing to a different beneficiary. Your spouse may want to fight you on this, especially if they stand to get a significant amount of money, but it should be hammered out in the divorce decree.
Divorce can be a messy business and hardly anyone leaves it with exactly what they want, but the key is compromise. This goes for life insurance claims as well. You and your ex-partner need to agree on what to do and have it written into the decree. You may not get what you want and your partner may not get what they want, but the decisions need to be made.
If you have no children, you may want to consider simply canceling the policy and getting another one for yourself when the time is right. The goal of life insurance is to provide financial stability in the event of your death. Since your spouse will no longer be your spouse, you may be under no legal or moral obligation to provide for them after your death.
