Life Insurance Ownership and Beneficiary Designations

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Life Insurance Beneficiary Designation Issues in Divorce

What is it?

You are (or are about to be) divorced, and you have life insurance that most likely designates your former spouse as the beneficiary. You've decided to keep your current policy. Should you change your beneficiary? If you have children, should they be your beneficiaries? If you do change the beneficiary, are there tax repercussions? There are many options to weigh when deciding who will be your beneficiary. Care should be taken to ensure that you make the most informed choice possible.

What factors affect your designation of beneficiary?

The beneficiary doesn't automatically change

Many married couples name each other as beneficiaries on their life insurance policies. This is a perfectly acceptable thing to do. In a majority of states, the designation of the spouse, by name, as beneficiary, entitles that spouse to the proceeds of the insured spouse's policy, even if they are divorced. This rule is true even if the former spouse remarries.

This could be a problem for you. Most divorced people don't want their ex-spouse to receive the benefits of their life insurance policy. If you fit that description, you need to change the beneficiary designation on your policy.

Caution:   In a few states, divorce automatically revokes a beneficiary designation that names the ex-spouse. Check your local jurisdiction for more information.

Tip:           If your life insurance is provided as part of an Employee Retirement Income Security Act (ERISA) plan, state law is preempted and only the specific terms of the plan will control. In that case, you don't have to worry about state law affecting your beneficiary designation.

The divorce decree

A divorce settlement may require that you maintain life insurance in favor of your ex-spouse as beneficiary. In these situations, deciding whether to change your beneficiary is easy: You can't. If you plan correctly though, the premiums you pay may be considered alimony and as such deductible for federal income tax purposes. For more information, see

New and Continuing Needs for Life Insurance.

Your estate as beneficiary

If you have living family members, naming your estate as the beneficiary is not usually a good idea. One of the great benefits of life insurance is that the death benefit is immediately (usually within a few days) paid to your family at the time of your death. When the benefit is payable to your estate, depending on the size of your estate, it may have to go through probate along with all of your other assets. This can tie up the money for as long as a year or possibly even longer.

Changing the beneficiary designation

The owner of a life insurance policy generally has the right to change the beneficiary designation as often as is desirable (assuming, of course, that the owner of the policy has not transferred that right).

It always has to be in writing; sometimes it has to be endorsed

Following the particular protocol of your insurance policy is essential. All insurers require that a beneficiary change be in writing. This is usually as easy as calling the insurer and requesting the proper paperwork. Some require that an endorsement be made to the policy itself. Endorsement is the physical act of changing the policy to reflect a new beneficiary. This is often done by adding a change of beneficiary designation to the existing policy.

What if you can't get the policy endorsed?

A common problem with the endorsement method of changing the beneficiary is that the beneficiary you want to replace (your ex-spouse) may have possession of the policy and refuse to release it. If the final divorce order requires that the beneficiary not be changed, you have no legal right to change it. But if there is no such order and the existing beneficiary wrongfully refuses to release the policy, the endorsement requirement can be bypassed. Notify your insurer and complete all the necessary forms. The change will be effective once all forms are complete.

Children as beneficiaries

In general

If there are children involved in your prior marriage, protecting them should be a priority. Much of the reason you purchased life insurance in the first place probably was to protect your children. Divorce may create additional needs, too. The death of the parent responsible for child support payments could have a devastating impact on your children's financial futures. See

New and Continuing Needs for Life Insurance.

Using life insurance to protect your children is an obvious and practical planning choice. There are a number of different ways to achieve it, however. The options range from the easy (e.g., naming your child as beneficiary of an existing insurance policy) to the more difficult (e.g., setting up a life insurance trust to purchase the policy on your child's behalf). Following are four basic options.

Designate your child as the beneficiary of your existing policy

The easiest way to protect your children is to designate them as the beneficiaries of your existing life insurance policy. Changing the designation is usually easy to do. Upon your death, the proceeds are paid directly to the child you designate. If the child is not old enough to receive the proceeds, a custodial account can be set up to receive the funds on the child's behalf.

The first drawback is that the death benefit proceeds paid from your policy are includable in your gross estate at death, which could mean estate tax burdens. Second, it may be difficult for you to make a single designation that accounts for multiple children, especially if there are children of a prior marriage involved. And third, you have no control over how the proceeds are used. Naming a beneficiary merely directs who gets paid.

Purchase an insurance policy on your life in your child's name

As a second option, you can acquire additional insurance on your life in your child's name. This option is slightly more involved, because you may have to go through a medical examination and underwriting. The benefit of purchasing the policy in your child's name is that at the time of your death, the proceeds will not be included in your taxable estate. Any policies you own at the time of your death are considered assets for estate tax purposes. If the child owns the policy, these taxes can be avoided. But note, there may be gift tax implications if you transfer an insurance policy from yourself to your child. When a life insurance policy is transferred from the original insured to a beneficiary, this transaction is deemed a gift and may be subject to gift tax. 

Caution:   In some instances, a child may not be able to be the owner of the policy if he or she is a minor. The age of majority differs from state to state, so check your local jurisdiction.

Tip:           During your lifetime, you can use the

annual gift tax exclusion

as a tax-free way to give money to your child. The child can then use this money to pay the premiums for an insurance policy on your life. This will protect your children's future while decreasing your tax burdens. For more information, see

New and Continuing Needs for Life Insurance.

There are drawbacks to this choice. First, you have no real control over how the funds are used. Second, it won't work for minor children.

Set up a trust to be funded by the proceeds of your policy

A third option is to set up a

life insurance trust

to receive the proceeds of your life insurance.

A trust has advantages because it provides flexibility in determining how insurance proceeds are paid after death. The trust, for instance, can provide for a spouse, a child, or multiple children. If the beneficiary is a minor at the time of your death, the trustee can be directed to invest the proceeds into specific investments until the child reaches a particular age. A trust is simply much more flexible than most life insurance contracts.

Caution:   Setting up a trust requires payment of legal costs to an attorney to draft the document and paying a trustee to administer it.

Set up an irrevocable life insurance trust to purchase a policy on your life

Perhaps the best option is to set up an irrevocable trust to purchase a policy on your life with your child named as beneficiary. This option has the benefits of trusts that were mentioned previously. It offers much flexibility. In addition, assuming that you retain no incidents of ownership in the policy, the proceeds of the insurance may not be includable in your taxable estate. If you give your beneficiary

Crummey powers

of withdrawal, your annual gift tax exclusion can be used to give the trust the money to pay for the premiums tax free.

The drawbacks? Well, it is irrevocable. Moreover, it costs money to set up a trust. You have to pay lawyer's fees, the trustee's fees, and possibly other expenses. Setting up a trust to purchase and manage the insurance is probably going to cost even more because it will have to manage the policy while you're alive and handle the proceeds when you're dead. Time is money when it comes to trusts. To summarize:

Protecting Your Child with Life Insurance - The Options

Life insurance proceeds and your taxable estate

In general

When you die, the life insurance proceeds may be includable in your

taxable estate. Generally, life insurance proceeds are includable an estate in the following situations:

·         When the proceeds are to be paid to the estate

·         When the proceeds are receivable for the benefit of the estate

·         When gifts of the policy have been made within three years of death

·         When incidents of ownership have been retained in the policy at the time of death

Transfers at divorce and estate taxes

Sometimes, the divorce agreement will provide that you must transfer an existing policy to your spouse or that you must name your former spouse as the beneficiary of your policy. A straight transfer of your existing policy to your former spouse, who becomes the policyowner, gives that spouse total control over the beneficiary designation. You are not able to make the designation contingent on, for example, your former spouse's death or remarriage.

When the divorce decree requires that you name your former spouse as beneficiary, it could result in increased estate taxes or complicated situations if you attempt to avoid them. If you want to avoid having the proceeds included as part of your taxable estate, you must not retain any "incidents of ownership."

Tip:           The best way to do this--while at the same time keeping some control over how the proceeds will be used--is to set up an

irrevocable life insurance trust.

You can fund this trust tax free by using your annual gift tax exclusion. The money you gift to the trust can be used to pay the premiums on the policy. The best part of a trust is that when you set it up, you can designate who will be paid and under what circumstances. To have the proceeds not included in your taxable estate, the trust needs to be irrevocable (i.e., you can't change the beneficiary down the road), and the proceeds cannot be payable to your estate.

Only gifts of present interest qualify for the annual gift tax exclusion. The problem is that when you give money to the trust, it's not really a present interest for the beneficiaries. If you want the payments you make to the trust to qualify as a gift of present interest, a beneficiary must be given a Crummey power. The Crummey power gives the beneficiary the right to withdraw funds from the trust for a short period of time after each annual gift is made (typically 15 to 30 days). This limited right of withdrawal is enough to make your gift to the trust qualify as a present interest. See Crummey Powers for more information.

Example(s):          As part of her divorce agreement, Melissa creates an irrevocable trust that is to be funded by a life insurance policy on her life. She directs the trustee that upon her death, the insurance proceeds are to be paid to her former spouse, Mark, if he is alive and unmarried. If he is not, then the proceeds are to be paid to the Museum of Art. If she gives Mark a Crummey power, Melissa can use her annual gift tax exclusion to gift money for the policy premiums to the trust. Results: (1) Mark is protected in case of Melissa's untimely death, (2) Melissa can make the proceeds payable to Mark only if he has not remarried or died, and (3) the proceeds are not included in Melissa's taxable estate.

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