Life Insurance Beneficiary Designation Issues in Divorce

 

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Life Insurance Beneficiary

Life Insurance Ownership and Beneficiary Designations

What is it?

In general

Two important considerations when purchasing a life insurance policy are selecting the owner and the beneficiary(ies). Who you choose can affect your income, gift, and estate taxes and can create solutions or cause problems for your family. Proper planning can help your family avoid unfortunate tax consequences, while poor planning can leave your family facing tax liabilities with no insurance proceeds to pay them. Too often, family members discover that life insurance proceeds were paid to someone else or are available for collection by creditors. Understanding ownership and beneficiary issues will help ensure that your life insurance proceeds will protect your family as you intend.

Importance of coordinating ownership and beneficiary

Life insurance is often a key component of a financial plan. If you don't coordinate your policy's ownership and beneficiary designations, your financial plan may not fulfill its intended purpose. For example, if you purchase life insurance to pay estate taxes, you will likely want to ensure that your policy's ownership is structured to keep the proceeds out of your taxable estate. For another example, if you want a trust to receive your life insurance proceeds but your policy names your spouse as beneficiary, your trust will go unfunded.

 

Life insurance ownership

Ownership rights

Life insurance is property with certain implied rights and privileges. The policyowner controls these rights, which are called incidents of ownership. A policyowner can keep or dispose of any or all of these rights. Ownership rights include the following:

  • The right to transfer, or to revoke the transfer of, ownership rights

  • The right to change certain policy provisions

  • The right to surrender or cancel the policy

  • The right to pledge the policy for a loan or to borrow against its cash value

  • The right to name and to change a beneficiary

  • The right to determine how beneficiaries will receive the death proceeds

Owning your own policy

Owning a policy on your own life is the most common form of ownership. With an individual policy, you pay the premiums, you are named as the insured on the policy, and you control all the ownership rights.

Owning a policy on another

Many people never think about life insurance in any way other than owning a policy on themselves. However, any person or legal entity can own life insurance on another person as long as the owner has an insurable interest in that person. An insurable interest exists when one person has a financial interest in another person's life. Spouses are assumed to have an insurable interest in each other. The same holds true for parents and children. Certain business relationships may also create an insurable interest, such as when a business insures its key employees or when a bank guarantees repayment of a loan with a life insurance policy on the borrower.

Having a trust own a policy

Many people choose to have trusts own their life insurance policies. This arrangement can provide two important benefits: It allows the trust, rather than the beneficiaries, to control how the proceeds will be used, and, if it is set up as an irrevocable trust, it removes the death proceeds from the estate.

Ownership guidelines

Who should own your life insurance policy? The answer depends on why you're purchasing the policy.

Income replacement

Owning your own policy--If the purpose of the policy is to replace your income for your family when you die, you should own your own policy, especially if you have a young family.

Having a spouse own your policy--Since nearly half of all marriages today end in divorce, adverse tax consequences could result if one spouse owns life insurance on the other. In some cases, divorce courts have required one spouse to transfer a life insurance policy to the other as part of the property settlement while continuing to pay the premiums. Generally, the IRS does not consider this a transfer for value. If it did, this could result in adverse income tax consequences to the beneficiary of any death benefits.

In addition, if you're divorcing, the divorce court may require you and your spouse to maintain life insurance policies for the benefit of your children. If you're alive when the children are grown, you may want to change the beneficiary(ies). If you've become uninsurable or a high insurance risk, you may want to keep the existing policy. If an ex-spouse owns the policy, you would lose this option.

Education costs

Faced with today's high education costs, most families apply for financial aid. When applying for financial aid, parents and child are expected to pay a certain percentage of income and assets for education expenses. Federal financial aid formulas exclude the cash value of life insurance from the countable assets. 

Caution:   Private colleges may include the cash value of life insurance in their analyses.

Estate liquidity

Estate liquidity may be a concern, especially if you expect the combined estates of you and your spouse to exceed your combined applicable exclusion amounts. Amounts over the applicable exclusion amount will be subject to estate taxes, and if taxes are owed, they will have to be paid within nine months of death. The applicable exclusion amount is $3.5 million for the estates of persons who die in 2009, ($7 million for combined estates) up from $2 million in 2008.

Owning a policy on your spouse--No estate liquidity benefits currently exist from owning a policy on your spouse.

Ownership by your children--A seemingly easy approach is to have your children own the policy. You can pay the premiums and have an unwritten agreement with them that they'll use the funds to pay the estate's obligations, although you can't require that or you'll retain an incident of ownership, thereby bringing the proceeds back into your estate. However, with human relationships being what they are and with your children possibly facing competing needs for the proceeds, children are rarely named as owners of their parents' insurance. Use of the insurance proceeds by your children, however, may subject them to gift tax for amounts paid to your estate.

Ownership by an irrevocable life insurance trust (ILIT)--One commonly used trust arrangement is called an irrevocable life insurance trust (ILIT). If a life insurance policy is transferred to a properly structured and funded ILIT, it guarantees that the death proceeds will not be included in your taxable estate. In establishing an ILIT, you set up or transfer the incidents of ownership to the trust, thereby allowing you to create a source of cash to provide estate liquidity without adding to your estate. Joint life (second-to-die) policies are frequently used in ILITs. These policies cover two lives and pay off at the death of the survivor. They are usually bought to provide cash to pay estate taxes. If the insured individuals owned the policies rather than the trust, the proceeds would be included in their taxable estates. 

Caution:   If you transfer a policy to a trust, the three-year rule applies. This requires that if you die within three years of transferring the policy to the trust, the IRS will include the value of the transferred policy in your taxable estate.

Life insurance beneficiary designation

In general

Just as a life insurance policy always has an owner, it also always has a beneficiary. The beneficiary is the person or entity named to receive the death proceeds when you die. You can name a beneficiary, or your policy may determine a beneficiary by default. If you don't name a beneficiary, your estate often becomes the beneficiary. When a policy is issued on your life, your beneficiary must have an insurable interest in you to avoid adverse income tax consequences.

Primary beneficiary

The primary beneficiary is the person or entity you name to have first rights to receive your life insurance proceeds when they become payable at your death.

Contingent beneficiary

The contingent beneficiary is the person or entity you name to receive your life insurance proceeds if the primary beneficiary dies before you.

Temporary beneficiary

As a policyholder, you generally reserve the right to change a beneficiary at any time. A revocable beneficiary is one that you can cancel anytime before you die. This means a revocable beneficiary's rights do not vest during your lifetime.

Permanent beneficiary

An irrevocable beneficiary is one you cannot cancel unless he or she consents. In other words, once you name an irrevocable beneficiary, you can't change it. An irrevocable beneficiary's rights to your death proceeds vest during your lifetime. This means that you may not exercise your ownership rights without written permission of the irrevocable beneficiary. You cannot borrow against the policy, pledge it as collateral, receive dividends, or surrender the policy.

Multiple beneficiaries

You may name multiple beneficiaries if you choose. There are no legal restrictions--and few company restrictions--on the number of beneficiaries you can designate. You can later change your beneficiaries provided you have retained that ownership right. 

Tip:           If you name multiple beneficiaries, you must also specify how much each beneficiary will receive (you may not want to give each beneficiary an equal share). Because of the numerous interest and dividend adjustments the insurance company must make, the death benefit check often does not equal the policy's face value. Thus, it's wise to distribute percentage shares to your beneficiaries or to designate one beneficiary to receive any balance.

Income, gift, and estate tax considerations

In general

The death proceeds of a life insurance policy are generally not subject to income tax. However, interest paid to your beneficiary from the date of your death to the date of payment of the death proceeds is income taxable to your beneficiary, although it's not included in your gross taxable estate.

Owning your own policy with spouse and children as beneficiary

Owning your own policy is the most common form of ownership and the most predictable as far as your beneficiaries are concerned. In most cases, when you own your own policy and the beneficiaries are your spouse or children, the death proceeds that they receive will not be subject to income tax. 

Caution:   However, the death proceeds are included in your gross estate. If the beneficiary is your spouse, you enjoy a special tax break called the unlimited marital deduction. This allows you to transfer as much as you want to a surviving spouse free from federal estate taxes. This transfer generally only delays the estate tax liability, however. When your surviving spouse dies, the estate he or she passes to your children or other beneficiaries may be subject to estate tax because the proceeds will not be eligible for the unlimited marital deduction.

 

Caution:   If you are divorced and own a policy with your children as beneficiaries, the proceeds may be subject to estate tax because they will not be eligible for the unlimited marital deduction.

Owning a policy on another

Some people still believe that it's beneficial for spouses to own life insurance on each other. However, since tax law changes created the unlimited marital deduction, there are no estate tax benefits and few income tax benefits from this arrangement. 

Example(s):          If Barry owns life insurance and dies leaving his wife, Blossom, as the sole beneficiary, the life insurance proceeds are included in his estate. However, due to the unlimited marital deduction, any assets Barry leaves Blossom are exempt from federal estate taxes.

 

If Blossom owned the policy on Barry's life, the death proceeds would generally not be subject to income tax and would be included in Barry's estate and thus not subject to estate tax. In other words, the tax effect would be the same as if Barry had owned the policy. However, if Blossom owned the policy and cashed it in during Barry's lifetime, she might see a small income tax saving if she and Barry file their income tax returns separately and she is in a lower income tax bracket.

 

Caution:   A serious potential gift tax problem can arise if there is a three-way split in ownership, insured, and beneficiary. If one spouse owns a policy on the other with the children named as beneficiaries, the IRS treats the spouse owning the policy as having given a gift to the children. Any gifts over the annual gift tax exclusion ($13,000 per donee in 2009, up from $12,000 in 2008) may be subject to federal gift tax.

 

Caution:   A problem can also arise if a divorce court requires one spouse to transfer a life insurance policy to the other as part of a property settlement, yet requires the transferring spouse to continue to pay the premiums. It's possible that the IRS could consider this a transfer for value, resulting in adverse income tax consequences for the beneficiaries of any death benefits.

Transferring ownership

If you transfer ownership to anyone who doesn't have an insurable interest in your life, the transfer will generally lead to income taxation of a portion of the death proceeds.

Giving life insurance as a gift

Life insurance is subject to estate and gift tax rules not applicable to other types of property. If you transfer your life insurance policy as a gift (regardless of its value) during the three years before your death, the death proceeds will be included in your estate. However, you may give any other property free of gift and estate tax as long as it doesn't exceed the annual gift tax exclusion amount per person in a given year.

Example(s):          If you give a $5,000 life insurance policy to your son today and you die in two years, the death proceeds are included in your estate. However, if you give your son any other property as long as it doesn't exceed the annual gift tax exclusion, it won't be included in your estate or subject to gift tax.

Effect of beneficiary on your estate

It was stated that if you retain any incidents of ownership in a policy at your death, the proceeds will be included in your taxable estate. However, even if ownership is held outside your estate, you must also be sure that you don't require your beneficiary to benefit your estate in any way if you want to keep the proceeds out of your estate. Whenever proceeds are paid to or for the benefit of an estate, they are included in the estate and subject to estate tax. For example, if you name your estate's executor as the beneficiary, and he or she is legally obligated to use the proceeds to pay expenses for the benefit of the estate, then the proceeds will be included in your estate and subject to estate tax.

Tip:           You can avoid this problem by establishing an ILIT to own the policy. As long as the terms allow it, the ILIT can lend money to the estate for the executor to pay the expenses, thereby allowing the proceeds to remain outside your estate.

Minor as beneficiary

One of the greatest mistakes you can make is to name minor children as beneficiaries, yet the most common combination of beneficiaries is a spouse followed by minor children. The courts generally will not allow minor children to directly receive the proceeds of a life insurance policy. If you have not established a trust or named a guardian for your children in your will, the courts may require a trust to be set up or a guardian to be appointed to manage the proceeds. Trustees will make all spending decisions and may not approve the use of funds as you would have preferred. There is a cost associated with establishing a trust that will vary depending on the trust's complexity and other factors.

 

Tip:           If you have a large estate, you should consider establishing a trust to receive the proceeds for minor children. The trust can hold the proceeds until the children are 25 to 35 years old. This may encourage your children to begin making their own way in life before inheriting substantial wealth.

 

Neither Forefield Inc. nor Forefield Advisor provides legal, taxation, or investment advice. All content provided by Forefield is protected by copyright. Forefield claims no liability for any modifications to its content and/or information provided by other sources.      

 
 
 
 

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