Divorce may change the family relationship, but it does not alter the basic fact that both spouses will continue to have life insurance needs. The plans established to protect their children may be even more important now than before. Another important objective for divorcing parents is their own financial welfare. While noncustodial parents may want to provide financially for their children, they will also want to do so in the most cost-effective way. Ultimately, taxes will be an important factor.
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Although you may not be the person to cover these needs, it’s important that you also remind your clients to consider and take action on their other insurance needs that will need review:
•Health insurance: Reevaluation is critical if one spouse was responsible for the health-care insurance of the other spouse and children. The soon-to-be uninsured spouse will need to explore alternative health insurance coverage. If both parents are covered, they need to determine who should be the primary and secondary providers for the children.
Here are a few tax rules to keep in mind:
- Alimony payments are tax deductible for the payer and taxable income to the recipient.
- Child-support payments are not tax deductible to the payer and are nontaxable to the recipient.
- Property transferred pursuant to a divorce is generally transferred tax-free.
- The cost basis is transferred to the recipient.
When applied to life insurance, these tax rules mean that the tax treatment of the premiums depends on the premium payer, the owner, the beneficiary and the purpose of the insurance in the divorce. Consider the following example.
Bart and Cynthia are divorcing. They have one child, Erik, who is 3 years old. Bart owns a $50,000 whole life policy and a $100,000 term policy. Cynthia is currently the named beneficiary on both policies. Bart will pay Cynthia both alimony and child support.
Cynthia’s attorney wants an insurance policy to secure both the alimony and child-support payments. The attorney would be satisfied with the transfer of the $50,000 whole life policy and the $100,000 term policy as security for the alimony. The attorney estimates about $250,000 in child support between now and the time Erik reaches 18. Thus, additional insurance is needed to secure this amount should Bart die before his son reaches legal age.
Bart and Cynthia have several options from which to choose. Some of them have trusts and should involve a qualified attorney to handle setting them up.
Decreasing term insurance—Bart’s alimony obligation decreases month by month and will last for about five years. Every time he makes a payment, the total liability toward Cynthia decreases. This rationale also applies to child support for Erik. As Erik approaches age 18, fewer child-support payments remain to be paid. If both parties believe that these liabilities are decreasing, then they may be best served if Bart purchases decreasing term insurance.
This is especially true if premium affordability is an issue. Decreasing term would enable Bart to purchase a lot of coverage at a very reasonable cost.
Permanent insurance—On the other hand, Cynthia’s attorney may be concerned that the ultimate liabilities are not, in fact, decreasing. The attorney would like to avoid additional court action to increase child support over the years as purchasing value decreases or Erik faces special needs such as private schooling.
From Bart’s perspective, decreasing term has no cash value from which to borrow should he face financial setbacks, making payments difficult. A permanent policy would be a viable solution if premiums are affordable.
An insurance trust for both alimony and child support—A planning alternative that may prove acceptable to both parties is the establishment of an insurance trust. In an insurance trust, a policy (or a group of policies) is placed in one trust established for the benefit of both the ex-spouse and child. This alternative offers several nontax advantages to Bart. The proceeds supporting the child-support payments will, in fact, be used for the benefit of his son. There is less possibility, as under nontrusteed plans, that the proceeds would come under Cynthia’s control for her own use. In addition, after the alimony obligation period, the freed up insurance securing the alimony can be redirected to benefit Erik. There is, however, a tax price to this plan. Since Cynthia’s rights are severely restricted by the trust, the insurance premiums are not deductible as alimony.
An insurance trust for child support combined with term or whole life for the spouse—If the alimony deductions are important to Bart, he may simply wish to set up an insurance trust for his son. To secure the alimony deductions, Bart would then have to either assign or purchase insurance policies for Cynthia’s benefit. The ideal situation, from Bart’s standpoint, might be to combine a decreasing term plan for Cynthia with a whole life trust insurance plan for Erik.
Divorce is usually a stressful time in a client’s life. Your understanding and empathy, combined with an understanding of the options a client has, will enable you to help your client navigate a financially prudent course.
Kirk Okumura is an LUTC author and editor. Contact him at Kirk.Okumura@TheAmericanCollege.edu.