Among the financial assets that can go through a divorce, life insurance may be easy to miss. Throughout the COVID-19 pandemic, these policies are coming into greater focus as divorcing spouses prepare for the unexpected.
Depending on the situation, you can handle life insurance in the following ways:
- Policies can remain in effect to provide insurance for children or a spouse as part of a settlement, and as necessary, may be transferred from one spouse to another.
- As a marital asset, you may be able to “cash out” a policy for its value to divide the proceeds.
- For legal reasons or to comply with the divorce terms, a new policy could need to be issued to replace an existing one.
To some extent, the options available also depend on the type of policy involved.
What Are Some Typical Life Insurance Policies?
Generally speaking, “whole” and “universal” coverage lasts for the life of the insured and increases in value over time. These policies may be sold for their “cash surrender” value or life benefit. “Term” policies offer coverage for a specified time. They typically lack a “surrender” value and aren’t divisible. However, in the insurance marketplace, a third party could be interested in buying a term policy as part of a life settlement (with potential tax consequences). “Blended” policies combine term and permanent life insurance coverage.
Permanent life insurance coverage can also pay dividends; “paid up” policies in place for several years may be worth more than some bonds.
For permanent alimony payments, “whole” or “universal” insurance may be best; term policies are better for when coverage is needed for a limited time, such as until a child reaches adulthood. Term life insurance policy coverage amounts can be set to reduce with time because the requirements tend to decline as children become adults.
Let’s explore some common ways to maintain or divide life insurance, depending on your state laws and the options available under each policy.
Keeping Life Insurance for Support Purposes
The couple can agree to maintain the policy or choose to buy a new one. For support purposes, the policy must offer enough coverage for future expenses. The settlement agreement should name the policy, its number, the face amount, and other details, such as how long it should exist.
Usually, the titled spouse must maintain coverage, which may generate estate tax. However, for the beneficiary spouse, there could be tax advantages if the policy is under their name; they might not have to pay estate tax on any proceeds from the titled spouse’s estate.
Confirm the spousal beneficiaries on any existing life insurance that will continue post-divorce. In case the policy lapses and is canceled for lack of payment, the custodial spouse might not trust the other spouse and want to pay for the coverage out of existing support payments. As protection, you may add a provision to the settlement agreement that prevents a policy cancellation, lapse, or change of the beneficiary. The receiving spouse can be added as a contact to the policy to be notified about any changes. Another thing to note is that though a custodial spouse may be named an “adult payee,” they might not be legally required to use the proceeds for child support.
Some experts advise against adding minor children as beneficiaries. For instance, when a child reaches the legal age of adulthood at 18 or 21, they may get full access to the money and lack the wisdom to handle it properly. Also, if no custodian is listed as a beneficiary, one could be appointed who might not be a surviving parent.
For new policies, the divorcing spouses may find a blend of term and permanent coverage more cost-effective. To help your client choose the right insurance, you need to determine if they want to keep the coverage beyond the requirements of the divorce decree. Before the settlement agreement is ready to sign, the spouse who will maintain the policy can check if they qualify for coverage; pre-existing health conditions may make it difficult. If coverage is too costly or hard to get, the settlement terms can allow for creating a trust or other estate planning options for future payouts.
Periodically review the policy to see if interest rates affect its performance and to check if other coverage options are available based on market conditions or to meet the beneficiaries’ current needs.
Dividing the Cash Value of Life Insurance
Based on state law, the policy could classify as separate or marital property. Courts have decided that life insurance policies bought during a marriage are marital, but they don’t always do so. States that define gifts and inheritances as separate property may treat insurance proceeds the same way. Equitable distribution states can also have certain rules that won’t always result in an even cash split.
During negotiations, when you divide the cash value, you don’t just want to consider replacing earned income; other support obligations could be involved, such as a child’s college tuition payments.
Another option, outside of cashing out the policy is to do a 1035 exchange to “roll” the cash value into a tax-deferred annuity; this prevents having to pay any taxes on cash received from the policy.
These are few ways to structure life insurance policies as part of a divorce to safeguard your clients’ futures. Learn more about complex financial matters in divorce cases through our CFL™ course. Find out more in our free information packet today.