A permanent life policy in a divorce: ownership, premiums and value

A permanent life policy is two things at once in a divorce: a promise of money at death, and an asset with a value today. Term insurance is mostly the first. A whole life or universal life policy is both, and the second half is what people forget to put on the list. Ownership, premiums, the cash value and the beneficiary form each need a decision, and the decree, the policy and the insurer's records have to say the same thing.

The four couples below are hypothetical. Their names and numbers are invented to show how the pieces fit, and every state handles property, support and beneficiary rules a little differently. Treat them as maps of the questions to ask your attorney, not as predictions of what a court will do.

Four questions that sort every case

Before the scenarios, four questions decide almost every outcome.

1. Who is the owner? The policy owner controls the policy, can borrow against it, surrender it, name or change the beneficiary and decide whether premiums continue. The owner is not always the insured.
2. Is there a cash value, and is it marital property? In many states a policy bought or funded during the marriage is divisible even if only one spouse's name is on it. In a community property state, premiums paid from marital earnings can give the other spouse an interest. See community property states and life insurance.
3. Does the decree or settlement require coverage? Courts often order a paying spouse to keep insurance in force to secure child support, alimony or a property settlement. The order controls what must be kept, not which policy, unless it names one.
4. Whose name is on the beneficiary form today? The insurer pays the person its records name, subject to any state law that cancels an ex-spouse's designation on divorce.

Hold those four in mind as you read.

Scenario 1: one spouse owns and the cash value gets divided

Say Marcus, 52, owns a whole life policy on his own life with a $400,000 death benefit. He and Elena, 50, have been married 18 years and have one adult child. The policy was bought early in the marriage. The statement shows a cash value of $62,000, an outstanding policy loan of $8,000, and total premiums paid of $48,000. Elena is the beneficiary.

The first job is to value the asset. The relevant number is not the $62,000 but the net after the loan: $62,000 minus $8,000 equals $54,000. If the couple agrees the policy is marital property to be split evenly, Elena's share is half of $54,000, which is $27,000.

Marcus has two ways to deal with that.

• Keep the policy and pay Elena $27,000 from other assets, such as her taking a larger share of a savings account. The policy stays in force, and Marcus keeps the same cost basis of $48,000 in it. Transfers of property between spouses incident to a divorce are generally tax-free under federal law, but the details are worth confirming with a tax professional.
• Surrender the policy and split the proceeds. Cash surrender value net of the loan is what the insurer pays, but the loan reduces it. Marcus's taxable gain is the amount received plus the loan satisfied, minus the basis: $62,000 minus $48,000 equals $14,000 of ordinary income, even though the check is smaller than the cash value. The family loses $400,000 of coverage, and both spouses are older and possibly more expensive to insure.

Marcus keeps the policy. The decree also removes Elena as beneficiary and names the adult child. The point of the scenario is that the buy-out depends on the net number and the tax number, not just the cash value on the front of a statement. The tool keep, surrender or sell your policy? is a way to test the alternatives for your own policy.

Scenario 2: the decree requires coverage, and the policy is far larger than needed

Say Greg, 41, and Tanya, 39, have a six-year-old child. The decree orders Greg to maintain $300,000 of life insurance with Tanya as trustee for the child until the child turns 18. That is 12 more years. Greg owns a whole life policy for $300,000. The annual premium is $5,400.

The order does not say which kind of policy. Greg has two reasonable ways to meet it. In both cases the numbers below are illustrations, not quotes.

• Keep the whole life policy. Twelve years of premiums come to 12 x $5,400, or $64,800. The policy also builds cash value and continues for life, which the order does not require.
• Buy a 15-year level term policy for $300,000 at an illustrative $55 a month. Twelve years of that is 12 x $55 x 12 months, or $7,920. The difference over the period is $64,800 minus $7,920, or $56,880 in premium.

The comparison is not simply about cost, because the whole life policy buys things the term policy does not: a death benefit that never expires and a cash value that is Greg's asset. If Greg wants lifetime coverage for his own reasons, or the cash value is part of his retirement, the larger premium has a purpose. If the only purpose is the order, term is the cheaper way to comply. See term vs whole life insurance: which fits you for the general trade-offs.

Tanya has her own interests to protect, and a few terms in the settlement matter more than the choice of policy:

• A death benefit that matches the obligation and is reviewed if it shrinks.
• A named trustee or custodian rather than the minor child directly.
• A right to receive proof that the policy is in force, such as an annual statement.
• Notice to Tanya if a premium goes unpaid, which many insurers can arrange through a third-party notice request.

If the policy lapses, the remedy is a motion in family court, not a claim on the insurer. That is slower and less certain than having the policy in force. Some settlements make Tanya the owner of a term policy on Greg's life so that she, rather than Greg, pays and controls it. Her attorney can say whether that fits their facts. The practical guide to writing these clauses is the blog post writing life insurance into a divorce settlement.

Scenario 3: the policy insures one spouse but the other owns it

Say Sam, 60, owns a universal life policy on his wife Priya, 58. Priya does not want her former husband to own coverage on her life, and Sam does not want to pay premiums on someone he is no longer married to. The policy has $45,000 of cash value and a $250,000 death benefit. Sam's cost basis is $38,000.

Three outcomes are common.

1. Transfer to Priya as owner. She becomes owner and insured, and the settlement credits Sam with the cash value. A transfer between spouses incident to a divorce is generally not taxable and is generally outside the transfer-for-value rule, but a tax professional should confirm that for the specific facts. See transferring ownership of a life insurance policy and the the transfer-for-value rule.
2. Sam keeps the policy and Priya consents. This can work, but the owner of a policy on another person's life can change the beneficiary and stop paying. Insurable interest, the requirement that the owner have a legitimate stake in the insured's life, is generally tested when the policy is issued, but state laws differ on the details, so ask.
3. Surrender or let it lapse. If neither wants it, Sam can surrender for the cash value. The gain would be $45,000 minus $38,000, or $7,000 of ordinary income, assuming no loan and no surrender charge.

The risk in outcome 2 is that Priya cannot control a policy on her own life. The owner can change the beneficiary or let the policy lapse, and the insurer may not tell her. If she needs the coverage, for example because she is the source of a spousal support obligation, she may prefer to own it. Our guide to policy owner vs insured: why it matters explains why the distinction matters.

Scenario 4: nothing was changed, and one policy is governed by a different law

Say Chris and Dana divorced three years ago. The decree mentions insurance only in general terms. Chris has two policies: an individual permanent policy for $200,000 and a group life benefit through his employer for $100,000. Dana is named on both. Chris never filed new forms. He dies.

What happens depends on facts the couple never checked.

• For the individual policy, many states have a revocation-on-divorce statute. If Chris's state has one that covers life insurance, the designation of Dana is treated as revoked and the proceeds go as if she had died before him. They would go to the contingent beneficiary, or the estate if there is none. That may be what Chris wanted. It may not be, if he meant Dana to hold money for their child.
• For the employer group benefit, if the plan is governed by the federal law known as ERISA, the plan must follow its own records. The Supreme Court has held that ERISA preempts a state revocation-on-divorce law for such plans, so Dana could be paid $100,000 even though the same state law removed her from the individual policy.

The result is two policies and two outcomes. The guide to divorce and your ex as beneficiary: revocation-on-divorce laws gives the rules in more detail, and life insurance and divorce covers the employer side. The remedy is simple and was available the whole time: submit a new beneficiary designation form to each insurer and plan, and name a contingent beneficiary too. See how to change your life insurance beneficiary.

One caution runs the other way. If the decree requires Chris to keep Dana as beneficiary, as security for support, the change he wants might violate the order. The same applies if the decree made Dana an irrevocable beneficiary, which generally means Chris cannot change the designation without her consent. Read the order before touching the form.

Premiums while the case is still pending

Months can pass between filing and a final decree, and the policy keeps costing money in the meantime. A missed premium during that stretch is how many couples lose coverage they meant to divide.

Three practical points help. First, keep paying. A court will usually expect the status quo on insurance to continue, and a lapse can look like a unilateral act. Second, find out who is the billing contact: if the owner's account is a joint bank account that is about to close, the automatic payment will fail and the notices may go to an address one spouse has left. Third, if one spouse owns a policy on the other and the relationship is hostile, the insured can ask the court to order that premiums be paid and notice be given. Insurers generally release policy information to the owner, so the insured usually needs the owner's consent or a court order to see the current status.

Premium payments made during the marriage are also part of the factual record about whose money built the cash value. Keep statements. In a community property state the source of each premium can matter, and in other states the date the policy was bought and funded often drives whether it is treated as marital property at all.

A related question is what to do about a policy loan that one spouse took during the marriage. A loan is a debt against the cash value, and the buy-out arithmetic in Scenario 1 shows why: ignore it and the numbers are wrong by the amount of the loan plus interest. Ask for a current loan payoff figure from the insurer before the settlement is signed, since interest keeps accruing every day.

What the four have in common

The couples reached different results, but the same habits shaped each one.

• Net values, not headline values. A loan, a surrender charge or a gain changes what the policy is worth to each person.
• The decree and the paperwork are separate documents. A court order does not, by itself, change an insurer's records, and an insurer's records do not follow the order unless the paperwork matches.
• Group coverage lives under different rules. Employer plans, military coverage and annuities each have their own beneficiary rules; do not assume the individual policy rule applies.
• A lapse is a quiet failure. Nobody calls when a premium goes unpaid on a policy someone else owns.

Questions to take to your attorney

1. Is the cash value marital property in our state, and how is it valued net of loans?
2. Do we want the policy kept, bought out or surrendered, and what is each option's tax effect?
3. Does the decree specify an amount, a duration, a beneficiary and proof of coverage?
4. Who should be the owner so that the required coverage cannot be quietly dropped?
5. Which of our policies are group or ERISA policies, and what must be filed to change them?
6. Should a trust or custodian receive the death benefit for minor children?

A short checklist after the decree

1. List every policy on both lives, individual and group.
2. Get each insurer's current beneficiary and ownership record in writing.
3. Complete the ownership transfers the settlement requires.
4. File new beneficiary forms, with contingent beneficiaries, and keep the confirmations.
5. Set a calendar reminder to confirm premiums are being paid on any policy that secures an obligation.
6. Update your will and any trust to match.

Key takeaways

• A permanent policy in a divorce is an asset with a net value (cash value minus loans) as well as a death benefit, and both need decisions.
• Surrendering can create taxable ordinary income equal to the gain over basis, and it ends the coverage when both people are older.
• A decree that requires insurance can usually be met with term insurance, but permanent coverage buys lifetime protection and an asset; decide which you need.
• State revocation-on-divorce laws may not apply to employer plans governed by ERISA, so change every beneficiary form yourself.
• Use a tax professional and a family law attorney before transferring ownership or surrendering.