Life Insurance Policies
It’s easy to forget about insurance policies that you’ve owned for decades, so a policy review is important. The first consideration is whether you want your divorcing spouse to be the beneficiary of your life insurance proceeds. Perhaps the beneficiary should be changed to your children, for example.
However, changing the beneficiary is not always an option. Divorcing spouses are considered to still have an “insurable interest” in one another. In fact, if you are paying alimony and/or child support, the court may order you to keep life insurance policies in effect to protect those payments in the event of your death. The court could even order you to purchase life insurance for that purpose if you don’t already own a policy.
Ownership of the policy may also be of concern to the judge because the policy owner controls the beneficiary designations and cash value of the policy. It’s possible that the policy may need to be transferred to an Irrevocable Life Insurance Trust or a trust established to purchase a new policy.
Retirement Plan Accounts
Normally the transfer of an IRA account to another person would be a taxable event. However, it’s not taxable if pursuant to a divorce decree. The spouse who receives the account would become the new owner of the IRA, subject to the normal tax rules going forward. As the new owner of the IRA, he or she could change or name new beneficiaries.
Qualified pension plans are handled differently. If rules are not carefully followed it could jeopardize the plan or cause immediate taxation. Modification of the plan is achieved through a judge’s Qualified Domestic Relations Order (QDRO) which can name the spouse as an alternative payee. The spouse is taxed on receipt of the plan’s funds, but the normal 10% early distribution tax does not apply. The spouse can also roll over the proceeds of the qualified plan to his or her own IRA.
There are beneficial rules regarding capital gains tax that apply to your personal residence. A married couple can exclude up to $500,000 profit in a home sale from capital gains tax if the home was owned and used as a primary residence for at least 2 of the previous 5 years. If the property is sold after the divorce, there are several rules to determine who qualifies as the owner to calculate the exclusion requirements.
If the husband in a divorce case transfers his ownership interests in the home to his wife, and she later sells it, she will only be entitled to the single person’s exclusion of $250,000 instead of the $500,000 exclusion available to married couples. It is often better (from a tax perspective) for the couple to sell the home prior to the divorce so they can use the full $500,000 exclusion, reduce taxes, and then split the proceeds.
Estate Planning Documents
Besides beneficiary designations on retirement plans and insurance policies, you’ll also need to remove the divorcing spouse as your executor, personal representative, trustee, health care agent, attorney under a power of attorney, and any other position of authority over your affairs; as well as any position as beneficiary of your estate.
In the event of a divorce, there are many other items that should be addressed by your professional advisors as well as those mentioned above. For example, you will no longer file joint tax returns. Each spouse may have a different investment philosophy and risk tolerance which will require reallocating investment assets. The court could consider an inheritance from your parents (or even an anticipated inheritance) in determining property settlements, so you’ll want to put protections in place for that.
Further complicating things is the fact that you may not be able to keep your same advisors – just when you need them most. They may be prevented from working with one or both spouses because of perceived or actual conflicts of interest. It’s also possible that the advisors really have a strong relationship with only one of the spouses, and the other spouse would be better served by a new advisor anyway.