Dividing a cash value policy in a divorce, with ownership and tax basis

When a divorce gives a whole life or universal life policy to one spouse, the change of owner is usually tax-free when it happens. The part that is easy to miss is that the tax does not disappear. The receiving spouse takes over the original owner's tax basis, so any gain built up inside the policy is still there, and it becomes the new owner's problem if the policy is later surrendered, or if it lapses with a loan outstanding. A fair division has to look at that hidden gain as well as the cash value.

This post explains the mechanism in four parts: how the transfer works, what "basis carries over" means with numbers, how a policy loan changes the picture and how the transfer-for-value rule is avoided. All figures are hypothetical. The tax rules here are federal and general. State property law decides who gets the policy, and a tax professional and the divorce attorneys should look at the real policy before anything is signed.

Start with what is being divided

A permanent policy has several separate pieces, and a settlement can treat each one differently.

• Ownership. The owner controls the policy: beneficiary, loans, surrender, payment. The owner is not always the insured.
• The insured life. The policy pays on the death of the insured. Divorce does not change who is insured.
• Cash value. The savings component, which the owner can borrow against or take out by surrender. See how cash value is taxed: withdrawals, loans and surrenders.
• The death benefit. What the beneficiary receives if the insured dies with the policy in force.
• Loans. Any amount the owner has borrowed against the cash value, with interest accruing.
• Basis. For tax purposes, generally the total premiums paid, less any tax-free amounts already received. See cost basis.

A term policy has no cash value and no basis to speak of, so divorces usually deal with it by ordering coverage, as described in life insurance and divorce. The rest of this post is about permanent policies.

Why the transfer is not taxed

Federal law has a rule for transfers between spouses and transfers incident to a divorce: under section 1041 of the Internal Revenue Code, no gain or loss is recognized on the transfer. The receiving spouse takes the transferring spouse's basis, which the law describes as a carryover basis. The transfer is treated like a gift for income tax purposes, even if the spouses trade it for something else in the settlement.

A transfer is "incident to divorce" under IRS guidance if it happens within a year after the marriage ends, or is related to the ending of the marriage. IRS Publication 504 describes the related-to-the-divorce timing: a transfer made under the divorce or separation instrument within six years after the marriage ends is treated as related. A transfer outside those windows needs more careful analysis. Section 1041 also does not apply if the receiving spouse is a nonresident alien.

Transferring ownership of a policy is done on the insurer's own form, often called an ownership change or absolute assignment, and the divorce decree or settlement agreement should direct it. See transferring ownership of a life insurance policy for the steps. The decree or agreement does not by itself change the insurer's records.

What "basis carries over" means

Basis is the number that decides the tax on a surrender. When the policy changes owners in the divorce, the new owner's basis is the old owner's basis, not the policy's current value. Here is the arithmetic.

Hypothetical. During the marriage, the couple paid $60,000 of premiums into a whole life policy owned by the husband. The cash surrender value is now $85,000. No loans, no dividends taken in cash.

• Basis: $60,000
• Cash value: $85,000
• Gain inside the policy: $85,000 - $60,000 = $25,000

The divorce awards the policy to the wife. At the transfer:

• No tax is due from either spouse.
• The wife's basis is $60,000, the same as her husband's was.
• The $25,000 gain moves with the policy.

Suppose that three years later, the wife surrenders the policy when its cash value is $95,000.

• Gain: $95,000 - $60,000 = $35,000
• The $35,000 is ordinary income to her, not capital gain, and it is reported to her by the insurer.

If instead she holds the policy until the insured dies, the death benefit is generally income-tax free to the beneficiary and the basis question does not arise. The hidden gain matters only if the policy is surrendered, lapses with a loan, or is sold.

Why it matters when the policy is divided "by value"

Settlements often balance a policy against other assets. If the cash value is $85,000, the parties might give the policy to one spouse and give the other $85,000 or half of it in other property. That sounds even, but the policy's value is not all spendable.

Hypothetical illustration. Compare $25,000 of embedded gain in the policy to $25,000 more in a savings account. If the receiving spouse eventually surrenders the policy, the $25,000 gain is taxed as ordinary income. At an illustrative combined rate of 24%, that is $25,000 x 0.24 = $6,000 of tax. The savings account has no such built-in tax on its principal. The two are not equal in after-tax terms.

That does not mean the policy should be discounted by the full tax, since the owner may never surrender it, and the tax may be avoided by keeping it until death or by a tax-free exchange. It does mean that the parties and their tax adviser should know the basis before agreeing to a value, and that "cash value" alone is an incomplete number.

To find the basis, ask the insurer for a policy history showing premiums paid, dividends and their uses, withdrawals and loans. A request through the owner is usually quickest. The insurer's annual statement and an in-force illustration are also useful. See figuring your cost basis in a cash value policy before any withdrawal for the arithmetic of working it out.

How a policy loan complicates the split

A loan makes the policy harder to value and creates a trap in the tax treatment.

Hypothetical. Same policy, now with a $30,000 loan against it.

• Cash value: $85,000
• Loan: $30,000
• Net cash value, what a surrender would pay in cash: $85,000 - $30,000 = $55,000
• Basis: $60,000

At a surrender, the tax is measured on the total amount received, which includes the loan the insurer cancels, not only the cash paid out.

• Amount received: $55,000 in cash + $30,000 loan canceled = $85,000
• Taxable gain: $85,000 - $60,000 = $25,000

So the gain is $25,000 whether or not there is a loan, but the cash the owner receives is only $55,000. If the policy lapses with the loan outstanding, the same logic applies and the owner may get no cash at all while still owing tax on the gain. The life insurance policy loans: how they work and what they risk guide and a lapse with an outstanding loan, worked through to the tax bill show this in detail, and the policy loan calculator lets you model a loan.

For the settlement, a loan raises questions that need answers in writing:

1. Who is responsible for the loan after the transfer? The recipient takes the policy with the loan attached unless the agreement says it is repaid first. If the husband repays it from his own funds before the transfer, the net value goes up.
2. How is the net value counted? The usual approach is to divide the net amount ($55,000 in the example) and to treat the loan as a liability that goes with the policy.
3. Who pays the loan interest? Interest accrues and can erode the policy if not paid, and rising loans can push the policy toward lapse.
4. What does the loan do to the death benefit? An outstanding loan is subtracted from what the beneficiary receives.
5. Is the policy a modified endowment contract? Transferring a policy does not change its status. A modified endowment contract is taxed gain-first on loans and withdrawals, with a possible 10% additional tax before age 59½, so the status should be confirmed. See modified endowment contracts and the 7-pay test.

Because a transferred policy's loan can alter how section 1041 applies in specific facts, particularly where liabilities exceed basis or a trust is involved, have the tax professional review the transfer before it is signed.

Putting it together: one policy, two ways to settle

Hypothetical. The policy has an $85,000 cash value, a $30,000 loan, a $60,000 basis and a net cash value of $55,000. The spouses agree to divide the net value equally, so each is entitled to $55,000 / 2 = $27,500.

• Settlement A. The wife takes the policy and the husband receives $27,500 of other property. She also takes the $25,000 of embedded gain and the loan.
• Settlement B. The husband keeps the policy, and the wife receives $27,500 of other property. He keeps the embedded gain and the loan.

On a plain cash-value basis the two settlements are equal. They differ if one spouse is likely to surrender the policy and the other is likely to hold it. A spouse who plans to keep the policy until death may reasonably accept the policy at its net value, because the gain may never be taxed. A spouse who plans to surrender will want an adjustment. If the parties used the illustrative 24% rate on the $25,000 gain, the tax of $6,000 would reduce the policy's after-tax value to $55,000 - $6,000 = $49,000, and half of that is $24,500, which is $3,000 less than the $27,500 each. Whether to make such an adjustment is a negotiation, and different attorneys approach it differently, but both sides should know the number exists before they agree.

Avoiding the transfer-for-value rule

The tax-free status of a death benefit is not automatic. If a policy is transferred for valuable consideration, the exclusion for the death benefit is limited to what the buyer paid plus later premiums, and the rest is taxable income. The the transfer-for-value rule guide covers the rule, and the key point for a divorce is that it has exceptions.

Two exceptions matter here.

1. Carryover basis. The rule does not apply when the buyer's basis is determined by reference to the seller's basis. A transfer incident to a divorce under section 1041 is such a case, so it fits the exception. This is why the divorce transfer is usually safe, even if something of value, such as an offsetting property award, is exchanged.
2. Transfer to the insured. The rule does not apply to a transfer to the insured.

The danger comes from transfers that fall outside both. Hypothetical: a wife owns a policy on her ex-husband's life, and ten years after the divorce, she sells it to a friend for $40,000. The friend is neither the insured nor in a protected class. The friend's tax-free portion of the death benefit would be limited to the price paid plus later premiums, which could turn most of the death benefit into taxable income.

Another trap: the spouse who owns the policy on their own life agrees, years after the divorce, to sell it to the ex-spouse, who is not the insured. That sale is not incident to divorce if the time windows have passed, and the buyer is not the insured, so the rule may apply.

To avoid the problem:

• Make the transfer in the divorce instrument, within the time windows, and say it is made incident to divorce.
• Do not stage a later sale between former spouses without a tax review.
• If the policy is to go to a trust for the children, have the attorneys confirm how that transfer is characterized.

Who should own it after the divorce

Ownership decisions follow from what the policy is for.

• To secure child support or alimony: the person protected may own it, or a trust may, so the payer cannot stop paying or change the beneficiary. See writing life insurance into a divorce settlement.
• As a savings asset: the spouse who wants the cash value and will pay the premiums owns it, with an offset for the other spouse.
• For the insured's own family: the insured keeps the policy and names new beneficiaries, with an offset to the other spouse for their share of the cash value.

The insured does not have to be the owner, but a former spouse who owns a policy on an ex-spouse needs insurable interest and the insured's consent. A court-ordered interest generally satisfies the insurer; ask it before planning around the point. See policy owner vs insured: why it matters.

After the transfer, change the beneficiary, confirm the owner in writing and note whether any irrevocable beneficiary designation must be consented to. Also review the premium: the new owner must pay it, and the insurer will not warn them about a change in the insured's health.

A checklist for the settlement table

1. Get a policy history from the insurer: premiums, dividends, loans, withdrawals and current cash value.
2. Calculate the basis and the embedded gain.
3. Confirm loans and who will carry them.
4. Confirm whether the policy is a modified endowment contract.
5. Decide who will own the policy and why.
6. State in the decree that the transfer is made incident to the divorce.
7. File the insurer's ownership change form and updated beneficiary designations.
8. Ask a tax professional to review before signing, especially when there is a loan, a large gain or a trust.

Key takeaways

• A policy transferred between spouses or incident to a divorce is generally not taxed at the transfer, and the new owner takes over the old owner's basis.
• Cash value overstates what a policy is worth after tax, because the embedded gain, value minus basis, becomes the new owner's income on surrender.
• A policy loan reduces the cash paid on surrender but not the taxable gain, and a lapse with a loan can create tax with no cash.
• The carryover-basis exception keeps a divorce transfer outside the transfer-for-value rule, but a later sale to someone who is not the insured can fall inside it.
• Get the policy history and a tax professional's review before the settlement fixes the value and the owner.