November 1, 2014
Life insurance is traditionally purchased to cover the risk that one spouse in a marriage will die and leave the surviving spouse unable to support his or herself. When the couple divorces you might think this risk no longer exists, as the two parties are no longer dependent on one another. However there are several reasons why life insurance may still be necessary, and this brings up a host of issues.
The most common use of life insurance is to secure alimony or child support. The payee spouse would lose these payments should the payor spouse die before the obligation ends. Life insurance on the payor’s life can be used to secure the lost payments.
Several issues arise when putting life insurance in place in a divorce, such as the type of life insurance to use, who should pay the premium and how long it should last.
The type of insurance depends on the obligation it is covering. For child support or alimony that lasts for a defined period, term insurance is usually the most cost-effective. Term premiums are adjusted annually to reflect the insured’s age but can also be purchased for level periods, in increments of 5 years, during which the premium stays the same. At the end of the level period the policy can be continued but the premium will jump up to reflect the insured’s age. Usually the policy is dropped at this point. If the level term period extends longer than the alimony or child support period, it can simply be dropped when the obligation ends.
Group term insurance, purchased through an employer, is not recommended as this insurance is usually dropped automatically if the employee leaves the company. Some group policies may be converted to individual policies but they can be more expensive than if bought in the marketplace.
Whole life insurance may be a better choice when the support obligation extends longer than 20 years. These policies are more expensive than term but build up a cash value that can be accessed later, or used to help pay the premium. There are many flavors of whole life from traditional to universal, variable and universal variable. These more complex policies offer some payment flexibility and investment opportunities.
Some spouses resent having to pay for insurance that could end up benefiting their ex. If the support obligation decreases over time but the insurance death benefit stays the same or increases this could result in a tax-free windfall to the ex. This can be addressed several ways. First, two or more term policies could be bought, and each cancelled as the obligation shrinks. Secondly, an Irrevocable Life Insurance Trust (ILIT) can be used to provide flexibility in paying out the insurance proceeds: a portion could be payable to the ex-spouse to cover remaining obligations with the remainder going to the new spouse or other beneficiaries.
Life insurance can also be used to maximize the payout of a pension plan. As an example, Paul is entitiled to a pension from his employer
when he retires, and the single-life payout is $1,000 per month. If Paul is obligated to name his ex-spouse Sally as his beneficiary his payment could fall by as much as 20% - in this example let’s assume it would go down to $800 per month and Sally would receive the same $800 per month at Paul’s death. Life insurance could be used to replace the $800 per month that Sally would receive (we would have to make assumptions as to when Paul would die and how long Sally would live afterwards to calculate that figure), which would allow Paul to elect the higher single-life payout. The cost of insurance would need to be weighed against the avoided reduction in the benefit payment to see if this strategy is worthwhile.
The requirement to keep a life insurance policy in place can be a point of contention in the divorce proceedings. The insured spouse may object to the cost of having to keep a policy in place as well as the potential for a windfall to the beneficiary (as described above.) It may be more palatable if the premium is deemed to be an alimony payment (thus reducing other alimony payments made directly to the ex-spouse.) Payments to a third party on behalf of or for the benefit of a former spouse can qualify as alimony if the payor is not obligated to make the payment. Therefore the insured cannot own the policy (if he did he would be obligated to pay the premium, thus it would not qualify as alimony.) The ex-spouse must own the policy and the divorce decree should require the insured to pay the premiums on the owner’s behalf, and state that these payments are to be considered alimony.
There are other good reasons for the beneficiary spouse to own the policy. In this way he or she will receive premium notices and annual statements, and can be assured that the beneficiary designation is not changed and the policy is not cancelled. If the beneficiary doesn’t own the policy it can still be monitored by requesting duplicate invoices, and some insurance companies offer automatic notification when the premium is paid.
In summary life insurance can be a valuable tool in divorce when used to secure or replace a payment obligation.
