How Divorce Can Affect Life Insurance Policies and Beneficiaries

Sorting out assets during the divorce process is challenging even in simple financial situations. While people inherently understand the importance of the house and even the retirement fund, an overlooked issue involves any life insurance policies. Life insurance is a critical hedge against future risks, and it arguably becomes more important when one of the parties may be paying alimony or child support.

What actually is the disposition of a life insurance policy during a divorce? Multiple factors come into play, so here is a closer look.

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Divorce’s Effect on the Policy

Term life insurance pays on death, and therefore is generally not a divisible asset during divorce. Instead, the beneficiary remains whoever the beneficiary is, and the insured party stays who they are. The only major issue here is that a court may order someone subject to an alimony or child support payment order to maintain an existing term life insurance policy. The goal is to preserve the value of the expected spousal or child support in the event of the payer’s death.

Whole and universal life insurance policies get trickier. These are assets that accrue value, and they typically are marital property. Notably, the death benefit for a whole or universal life insurance policy is not divisible. It operates no differently than a term life insurance policy.

What is different is the cash value of a whole or universal life insurance policy. This is a divisible marital asset, and a divorce agreement or court order needs to account for its value.

There are several ways to account for the division. One spouse could simply keep the policy. They would then offset the other partner’s loss with another asset. Alternatively, the partners could cash the policy and split the difference per a divorce agreement.

It is sometimes possible to split the policy into two policies. However, insurers frequently have great leeway in deciding whether to allow this.

You could also keep the policy jointly. Both partners enter an agreement regarding premiums and beneficiaries. This can be especially useful when the beneficiary is a child from their marriage.

Check the policy for terms that terminate it or cash it out upon divorce. Some insurers include this requirement. The disposition of the policy will then follow whatever the written terms were once the divorce becomes final. This is the only scenario where the disposition of the policy is automatic.

You should also be aware of your state’s laws requiring revocation of a policy upon divorce. While this is the minority of U.S. states, some states revoke the former partner’s designation when the divorce becomes final. Know the rules for the state of residency of the policy at the time that you plan to finalize the divorce. This can get tricky if the two former partners are living in different states.

An additional complication is whether the life insurance policy arises from an employer benefit plan. Employee Retirement Income Security Act almost always overrides state laws that end designations automatically. The disposition of the policy follows whatever the plan’s documents say, which means an ex can keep the benefits if that’s what the letter of the plan says.

Because of the many possible scenarios, it is wise if there is a significant life insurance policy at stake to work with an experienced divorce lawyer like the family law attorneys at Davis & Associates. An attorney can work with your ex and their counsel to determine what is the best agreement for handling the life insurance policy. In many cases, the life insurance policy becomes a useful bargaining chip, particularly if you’d prefer a different asset of similar value.

Possible Tax Events

The good news is that moving a policy to your spouse or your former partner as part of the divorce usually does not trigger a tax event. In legalese, the term is “incident to divorce.” This means that the transfer must occur within one year of the divorce. There are some scenarios where, if the divorce ends up dragging out, the period can go longer under a decree or a settlement.

The new owner does take on the cost basis, which affects the eventual tax disposition of the policy. This matters when you cash out, since the basis cost will reduce the eventual tax bill. Death benefits usually carry over free of income tax.

Be aware that transferring the policy to anyone besides one of the two former spouses or the named beneficiary will trigger a tax event. Also, cashing out the policy almost always triggers a tax event.

Legal Issues

A court order can upend a lot of this because judges have significant discretion to ensure that benefits are paid and that children are protected as beneficiaries. A judge may order one party to maintain the policy as a hedge against their possible death or injury. The standard version of this kind of court order arises when the alimony or child support at stake is significant, and the disruption caused by the payer’s death would be severe for the recipient.

A settlement or court order can also create a guardian structure for any payments of death benefits that would be due to a minor. The agreement or the order would position a person or a trust to handle the money in the minor’s interests until such time they came of age.

When this kind of agreement or order is possible, it is very important to leave the life insurance policy alone. Do not attempt to change the ownership or the beneficiary. Let the legal process play out. Otherwise, there is a risk that a court will sanction you. In extreme cases, a judge may deem it a form of fraud.

Understand what is likely to happen with your life insurance policy as your divorce proceeds. Consult with a divorce lawyer to learn the applicable state and federal rules. Consider options, such as reaching a formal settlement that determines the policy’s disposition without getting into other complexities.