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For this month's Wealth IQ Report, we discuss a life event that affects approximately 10% of the U.S. population: divorce. With roughly 43% of all marriages ending in divorce, investors need to understand how divorce affects their finances, taxes, and estate planning needs.
Divorce and Risk Management
New and Continuing Needs for Life Insurance in Divorce
Divorce and Estate Planning
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Darren Whissen
Divorce and Risk Management
What is risk management and how is it relevant to divorce?
Risk may be defined as the possibility of harm, injury, loss, danger, or destruction. One option to help manage risk is to purchase sufficient insurance to pay for losses. Risk management is an important topic for separated or divorcing couples. When a divorce occurs, the selection of life and health insurance beneficiaries may have to be revised and, in some cases, insurance coverage may terminate. Because it's common for one spouse to maintain health insurance for the family, the breakup of a marriage can have serious consequences for the nonworking spouse. Therefore, it's important to revisit the issue of risk management when a divorce seems likely.
How will a divorce affect your health insurance coverage?
Often, one spouse participates in a group health insurance plan at work; typically, this plan will provide coverage for both spouses. When a divorce occurs, coverage for the nonemployee spouse may eventually end (unless the divorce decree requires a spouse to continue carrying coverage on the ex-spouse).
However, temporary protection may be provided by the Consolidated Omnibus Reconciliation Act of 1986, COBRA. This federal law was designed to protect employees of larger companies (20 or more workers) and their dependents from losing group insurance coverage as a result of job loss or divorce. If your former spouse maintained family health coverage through work, you may (at your own expense) continue this group coverage for up to 36 months after the divorce or legal separation. This COBRA coverage will terminate sooner than 36 months, if you remarry or obtain coverage under another group health plan.
Caution: Bear in mind that COBRA doesn't apply to a group health plan if the employer maintaining the plan normally employs fewer than 20 employees on a typical business day. Also, certain governmental plans and church-sponsored plans are exempted from the act.
Caution: Several states have enacted laws that preserve a spouse's eligibility for health insurance after separation and divorce. These laws may provide a former spouse with more generous rights than those provided under COBRA.
Health insurance for you
When analyzing the issue of health insurance during divorce proceedings, you should consider whether it's cheaper to continue COBRA coverage, to purchase individual coverage, or to seek coverage from your own employer (if you're employed). For young homemakers with children and older homemakers who sacrificed career opportunities for domestic concerns, COBRA coverage and purchasing individual policies may be the only choices available. Keep the cost of insurance in mind. Individual policies are often more expensive than group policies, so COBRA coverage is certainly attractive. If you decide to exercise your COBRA rights, note that your cost of continuing COBRA coverage can't exceed 102 percent of the cost to the plan for providing identical benefits to an active participant. Additionally, be aware that you have the right to pay the premiums in monthly installments. For older persons, it may be wise to purchase individual health insurance or to insist, in the divorce agreement, that the working spouse maintain health coverage for you. Otherwise, when the COBRA coverage terminates after 36 months, you may find that poor health in your later years presents an insurability problem or that the cost of your insurance is exorbitant. Nevertheless, federal law may provide certain protection regarding pre-existing conditions.
Health insurance for your children
When there are children born of the marriage, the child support section of the divorce agreement should address the issue of health insurance for the children--you need to assign responsibility for providing health insurance. A federal law, the Omnibus Reconciliation Act of 1993, provides some protection to those spouses who have custody of the children. This act provides for the existence of a court order that secures your children's continued health insurance coverage. This court order is called a Qualified Medical Child Support Order (QMCSO). In accordance with this order, custodial parents have the right to obtain health insurance coverage for the children through the noncustodial parent's group health plan (if any). The children can't be denied coverage by the noncustodial parent, that parent's employer, or that parent's insurance company based on any of the following reasons:
- The child doesn't live with the noncustodial parent
- The child isn't claimed as a dependent on the noncustodial parent's federal income tax return, or
- The child lives outside of the plan's service area
Along with covering an employee's child under an employer-sponsored health care plan, a QMCSO can require the following:
- Deducting the premium out of the employee's paycheck
- Making insurance reimbursements directly to the nonemployee parent (if that parent pays the provider), and
- Giving the nonemployee parent information requested regarding the health care plan and reimbursements
To qualify as a QMCSO, the court order must:
- Create the child's right to receive benefits under the group plan
- Specify the employed parent's name and last known mailing address and the names of each child covered by the plan
- Specify each plan and time frame to which the order applies, and
- Not require the plan to provide any additional benefits not actually provided in the plan
How will a divorce affect your life insurance coverage?
When you get a divorce, you need to reconsider whom to name as the beneficiary of your life insurance policies. Perhaps you might wish to name your children as sole beneficiaries. If so, be aware that if your children are under age 18 when you die, the probate court will require that a guardian be appointed to manage the insurance proceeds until your children reach age 18.
You might also consider naming your ex-spouse as beneficiary of your life insurance policy. Although this may not be your preference, it may be required as part of your divorce agreement. Because alimony terminates on the death of the payer, for example, life insurance may be used as a tool to guarantee a stream of income if the alimony-paying spouse passes away. This is equally important to ensure that child-support money will continue to be available. Often the parties will stipulate in the divorce decree that life insurance will be carried on the life of the payer to replace alimony and/or child support in the event of death.
In such cases, the recipient-spouse should either own the life insurance policy or be an irrevocable beneficiary in order to ensure payment of the premiums (and to create favorable tax treatment for the payer of the premiums, if alimony is involved).
Example: Assume Liz was receiving $300 per month in alimony from her ex-husband, Frank. The court had ordered Frank to carry life insurance on his life (payable to Liz) for as long as alimony was required. After five years, Frank stopped paying his insurance premiums and the policy lapsed. When Frank died of a heart attack the next month, alimony payments ceased and Liz learned (for the first time) that there would be no life insurance proceeds forthcoming.
Tip: If your divorce agreement stipulates that a new insurance policy will be purchased on the life of the working spouse (to secure alimony or child support), make sure that the working spouse applies for the policy before the divorce is final. That way, if he or she can't pass the physical exam and is uninsurable, there's still time to modify the final property settlement to make up for this problem.
Should disability insurance be considered?
Another risk to your income is that you may become disabled or your ex-spouse (who is paying your support) may become disabled. During the discovery process of divorce, your attorney should uncover information about any disability plans at your spouse's place of employment.
While a former spouse can't own a disability policy on their ex-spouse, the former spouse can pay the premiums on the policy to ensure that it stays in force. Disability insurance is important and is a topic you may wish to address in your divorce agreement.
Example: Assume Ken agreed to pay his ex-wife $2,000-per-month alimony, based on his $7,000-per- month salary. After the divorce was finalized, Ken suffered an accident and became disabled. If he has no disability insurance and no salary, he can go back to court to get his alimony obligation modified. If Ken has disability insurance, he might receive $5,000 per month tax-free and could probably continue paying the same amount of alimony.
What about property insurance?
Real and personal property must be insured by the actual owner of the property. Therefore, applicable insurance policies must be modified or rewritten to reflect the proper owner as the insured. With respect to married homeowners, for example, the title is usually held by both spouses as joint tenants or as tenants by the entirety. In such cases, the death of one spouse will automatically vest the title to the other spouse. At the time of a divorce, a new deed should be drawn up to reflect the new arrangement and the homeowner's policy should be updated.
Divorce negotiations provide you with a number of choices regarding the house. For instance, the house can be sold immediately and the proceeds divided. Or, both spouses can continue to own the house jointly (with a view toward a future sale). Alternatively, one spouse can keep the house and buy out the other's interest. Finally, one spouse can be awarded the house without trading other assets in return.
Again, it's the divorce agreement that should address the issue of the title to assets and property insurance. In cases involving an older homemaker or a younger spouse who has custody of children, it's not uncommon for a judge to award the entire house to such a party and to order that the other spouse pay the mortgage, property taxes, and subsidize the homeowner's insurance.
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New and Continuing Needs for Life Insurance in Divorce
What is it?
You and your spouse have recently divorced or are planning to divorce. Either one of you may have life insurance policies in effect, and you probably have questions about your new and continuing needs for life insurance. You may be wondering if you still need to have life insurance coverage at all. More likely, you're wondering whether you will need additional insurance to protect your alimony or child support payments.
While married, you purchased life insurance as protection in case of the untimely death of yourself or your spouse. After a divorce, life insurance is still valuable protection for yourself and your family. Many of the concerns you shared while married will still apply after divorce. Almost as certainly, divorce will also create new concerns for you and your family.
Protecting your children
Insure the life of noncustodial parent
Much of the reason you purchased life insurance in the first place may have been to protect your children. The death of the parent responsible for child support payments could have a devastating impact on your children's financial future. The lost income could mean financial hardships for children who are dependent on the support for their basic needs and educational expenses. You will likely want to ensure that there is a sufficient amount of insurance on the life of the support-paying spouse to protect the children's financial future.
Change the beneficiary designation
Divorce may also create beneficiary designation issues. Your former spouse is often the beneficiary of your life insurance policy. Many people overlook the need to change the designation after a divorce--in fact, it should be one of the first things you do. Designating your child as the beneficiary is one option; designating your estate is another.
Caution: Designating the estate isn't as beneficial, however, because it could greatly increase the value of your estate and, thus, increase the potential estate tax exposure at the time of your death. As long as you live for three years after the designation, making your child beneficiary of an irrevocable life insurance trust can avoid these estate tax consequences. See Introduction to Estate Planning for more details.
Protecting your alimony/child-support payments
In general
If you are receiving alimony or child support payments, you should protect those payments by insuring the life of your former spouse. Support payments can be critical to your own well-being, as well as to your children's. There are some options.
Be named the beneficiary of your former spouse's policy
As part of the divorce settlement, the easiest option is to be named the beneficiary of any existing policies on your spouse's life. This will protect you in the event of your former spouse's untimely death.
Caution: Be aware that you will have no real control over the policy. The problem is that if your former spouse still owns the policy, anything can happen. He or she may take loans on the policy or fail to pay the premiums. There is more than one story in the big city of an unscrupulous spouse changing the beneficiary designation or taking a loan on the policy, leaving an unsuspecting former spouse with little or no protection.
Have existing life insurance policies transferred to you
Having the policy transferred or assigned to you can be a valuable alimony-protection tool. When you own the policy, you are protected from your former spouse taking loans or making any other changes to it. Another benefit of ownership is that the insurance company notifies you if the premium is not paid on time. Such a transfer should be part of the divorce agreement to avoid gift tax consequences.
You may also be able to have the divorce agreement require your former spouse to continue paying the premiums on the policy transferred to you. Depending on the cost of the premiums, this can be a big help. If there's some controversy over who will pay the premiums, think of it this way: If you pay them, you have the peace of mind to know that they are being paid in a timely fashion. Moreover, if your former spouse pays the premiums, they will likely be considered alimony and, therefore, taxable to you. More on tax considerations later.
Purchase additional insurance on your former spouse
As a slightly more difficult option, purchasing a policy on your former spouse can give you the protection you need along with much more control than if you are just the designated beneficiary. If it's too late to make any changes to the divorce or separation agreement, purchasing a separate insurance policy on the life of the former spouse may be your only option for protecting your alimony payments.
Caution: Buying life insurance can be an expensive proposition, especially if your former spouse is older or in poor health.
Caution: An unwilling ex-spouse may not go along with extensive physical examinations or underwriting that may be required to purchase a new policy. It's a good idea to make sure that the former spouse is willing to be insured before relying on this option.
Seek to have the alimony/child-support payments increased to cover the cost of additional insurance
It may be the most beneficial option for both of you to increase the alimony or child-support payments by the amount necessary to pay for a new policy. You and your spouse can agree to this as part of the divorce settlement. This option gives you total control over the policy while at the same time protecting your alimony/child support payments.
Caution: Remember that the alimony payments you receive are considered taxable income to you and are deductible by your former spouse. Notice the tax consequences in the following example.
Example: As part of their divorce agreement, John's former spouse, Mary, is required to pay $500 per month in child support to John for their daughter, Abby (whom John has custody of) until she reaches age 18. Abby is 8 years old. The parties agree in the divorce settlement that the $500 includes the cost of a 10-year term life insurance policy on Mary's life. Results: (1) The child support payments are protected until Abby reaches age 18, when they are to end normally, (2) Mary is happy because term life insurance is inexpensive, and (3) John is happy that the additional child support payments are not taxable to him as income.
Protecting yourself as the noncustodial parent
Insure the life of the custodial parent
Insuring the life of the custodial parent can protect you and the well-being of your children. If the custodial parent dies, you're the one who will have to take custody of the children. Financially, this could be a very difficult situation. All of the costs of raising the children will now fall on you as the only parent. From basic needs to higher education, these costs can be extensive. A policy on your former spouse's life can prove invaluable in meeting these costs.
Options if you have remarried
Qualified terminable interest property (QTIP) trust
If you have remarried, a QTIP trust can be a great method for supporting your new spouse, protecting children of a prior marriage, and deferring estate taxes. Upon your death, a QTIP trust holds assets for the benefit of your current spouse for his or her life and then pays the remaining funds to a third person (typically your children) designated by you. Since the transfer is between spouses, gift taxes are avoided because the amounts used to fund the QTIP trust fall within the unlimited marital deduction. The QTIP trust also defers possible estate tax on the trust amount until the death of the surviving spouse.
Caution: The potential downside of the QTIP trust is that the children (or whomever you designate) will not be able to make use of the assets until the death of your spouse.
What are the tax considerations?
The gift tax applies to transfers and purchases of insurance policies
As part of the divorce settlement, you may decide to transfer your existing life insurance policy or purchase a new policy for your spouse or children.
Caution: Transfer of an existing cash value policy to your ex-spouse or your children may entail a substantial federal gift tax.
Tip: If the policy is transferred to your former spouse prior to--or as part of--the divorce, gift taxes are avoided because the transfer is between spouses. A little pre-divorce planning can go a long way.
Can the payment of insurance premiums be considered alimony?
The payment of insurance premiums can be considered alimony under certain circumstances. Payments that are considered alimony are deductible by the payor (the person making the payments) and includable as taxable income to the payee (the person receiving the payments). So, if the premium payments are considered alimony, the payor spouse gets a tax benefit.
Generally, premiums paid by the payor spouse for life insurance on the payor's life made under the terms of the divorce or separation instrument will qualify as alimony to the extent that the payee spouse is the owner of the policy. For the payment of premiums to be considered alimony, the beneficiary spouse must be made the owner and the irrevocable beneficiary of the policy. There cannot be any contingencies. For example, an agreement to pay insurance premiums until the payee spouse remarries or dies is a contingent one and, therefore, not tax-deductible as alimony.
Tip: If you can plan it ahead of time, it is better for the payor to agree to increase the amount of cash alimony paid by the amount necessary for the payee spouse to secure insurance on the payor's life and pay the premiums. This will be deductible as alimony by the payor and can be limited to contingent circumstances, such as remarriage or death. This solution serves both spouses' interests by creating a tax deduction for the payor and giving the payee complete control over the insurance policy.
Example: Spouse A agrees to an alimony payment of $500 per month until Spouse B dies or remarries. Spouse B agrees to purchase insurance on the life of A with the money paid in alimony. Consequences: Spouse A receives a $6,000 ($500 X 12) income-tax deduction for alimony payments. Spouse B gets $6,000 additional income for income-tax purposes but also gets a substitute for the lost alimony if Spouse A dies.
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Divorce and Estate Planning
How does divorce affect estate planning?
Wills for both spouses are often drawn up sometime during the marriage--particularly if there are children involved. When divorce is contemplated, the selection of beneficiaries and executors will likely be revised to reflect the absence of your former spouse. Additionally, you will need to re-examine the gift and estate tax aspects of your estate plan. For these reasons, many divorcing couples revise their estate planning documents during the period of separation or soon after the divorce has been finalized.
What should you be concerned about during the separation period?
If divorce proceedings have begun, it's important to draft a formal separation agreement as soon as possible, establishing the spouses' rights regarding property, debts, temporary alimony, child support, and child custody. When drafting the provisions, you (or your attorney) will want to consider the possibility of your spouse dying prior to entry of the final divorce decree. You may wish to make the agreement binding on heirs and assigns so that the obligations will continue if one party dies.
If you expect to receive alimony and child support from your spouse, you may want to require (in the separation agreement) that your spouse buy a life insurance policy (or keep the existing one in force), naming you as the beneficiary. The policy should be in an amount sufficient to cover the sum of support obligations and property distribution payments contemplated. You could even be named as the owner of the policy insuring your spouse's life.
Similarly, your agreement might require your spouse to maintain minimum will provisions in favor of you (and/or your children). Often, the parties to a separation agreement include a provision that both waive the right to elect a share of the estate of the other in the event that one party dies before the divorce decree is entered.
When revising your estate plan, which areas require particular note?
First of all, you should make the necessary changes in your will or other estate planning documents to ensure that your former spouse isn't named as your personal representative, successor trustee, beneficiary, or holder of the power of attorney. A new will will likely be drafted during the separation period. Note that in some states, wills drawn up during a marriage are considered void after a divorce unless specifically ratified after the divorce. This means that intestacy rules would apply, instead of the will being controlling.
Next, consider gift tax implications if funding your children's education is required by your property settlement. Although your direct tuition payments (even for adult children) are exempt from gift tax when required by a property settlement agreement, be aware that your payments for related educational expenses (e.g., books and room and board) may be subject to gift tax.
Example: Liz and Frank have a daughter, Carol. Carol has reached the age of majority under state law. When the couple divorced, Frank agreed (as part of the settlement) to pay for Carol's college tuition, books, room, and board. During the year, Frank pays $20,000 tuition directly to Carol's university, and he gives Carol $15,000 in cash for living expenses. The tuition isn't a taxable gift, but the $15,000 in cash will be treated as a taxable gift.
Finally, consider the absence of the unlimited marital deduction. An unlimited marital deduction is allowed for qualifying transfers (gifts) to one's spouse during lifetime or at death. Because this estate and gift tax deduction is one of the most important estate planning tools for married couples, your loss of this tool at divorce can affect your tax situation adversely when you die.
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Disclosures
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of an investment in debt securities will change as interest rates fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. Investments in high-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income.
The opinions in the preceding commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole.
This material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict performance of any investment. Investing involves risk, including possible loss of principal. Investors should consult with a financial advisor prior to making an investment decision.
Diversification does not guarantee a profit or protect against loss in a declining market.
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