Top Three Insurance Planning Mistakes in Divorce

By Igor Zey, MSFS, CFP®, CLU®, ChFC®, CAP®, AEP



The mistakes one could make with respect to financial issues in the context of divorce are countless.  This article is intended to add to your awareness of the three most common mistakes people make with respect to life insurance.

  1. Ineffective Beneficiary Designations

A very common problem, usually arises when clients fail to review beneficiary designations after the initial designation. Because of divorce, or other changes in circumstance, it is imperative that clients review these designations to ensure that the intended beneficiaries will receive the benefits of a life insurance policy, annuity, IRA or other Qualified Plan (QP) at the insured’s death.  Under ERISA and the Code, any court order that tries to divide pension interests (other than IRAs) must be a “qualified domestic relations order,” or “QDRO.” ERISA requires a pension plan administrator to obey the order if it is a QDRO.  Simple enough? But wait!

In Egelhoff v. Egelhoff the Supreme Court has ruled that ERISA preempts state laws that automatically revoke spousal beneficiary designations after a divorce. The ruling applies to all ERISA-covered plans, such as life insurance, retirement and most types of executive deferred compensation plans.

The facts of the case: During their marriage, David Egelhoff designated his second wife as his beneficiary under an employer-sponsored life insurance plan and a 401(k) plan. When the couple later divorced, their divorce decree granted Egelhoff 100 percent of his Boeing 401(k) account, but made no mention of his life insurance policy. Eight months later he died, leaving his children from his first marriage as his statutory heirs. His second wife remained the designated beneficiary under the life insurance policy and his 401(k) plan. Egelhoff’s children sued their father’s ex-spouse, claiming that Washington state law had revoked her designation as beneficiary after the divorce. The highest court of the state upheld the state law, meaning that the children were entitled to the life insurance proceeds and the 401(k) plan.

However, the Supreme Court reversed the state court, ruling that ERISA preempts state laws that purport to revoke spousal beneficiary designations upon divorce. In a brief filed with the Supreme Court, the Department of Labor had argued in favor of preemption.

Egelhoff should serve to increase awareness of the need to review death benefit beneficiary designations after a divorce. Such designations should be modified, if necessary, to reflect the participant’s current intentions, as well as the provisions of any property settlement agreements executed in connection with the divorce.

Moreover, if a minor is the intended beneficiary, the client should consider naming a trust or custodian as beneficiary under the Uniformed Transfers to Minors Act (UTMA) to avoid potential court problems. It is generally not advisable to name a trust or estate as the beneficiary of an IRA, 401(k) or other QP so as not to deny an option to stretch out the payments over the beneficiary’s lifetime.

  1. Improper Individual Ownership Designations of Life Insurance Policies

Often in the name of expediency and simplicity the insured may decide to have an ex-spouse, child or other family member  own a life insurance policy on his/her life. Although not always problematic, the client should be aware of some potential issues that might occur.

-If the policy’s ownership is transferred to ex-spouse outside of the court order, it may create a transfer-for-value problem and gift tax exposure as well.

– Out-of-order Death: The ex-spouse that owns the policy on the insured dies first. Who becomes the new policy owner could turn into a big issue!

-Creditors: Individually owned policies are more vulnerable to creditor’s claims than policies owned by Trusts.

-Minor children should never be the owners/beneficiaries of life insurance policies.

-Unintended Gifting: Assume that one of the children owns the policy on the parent and he and his siblings are the beneficiaries. When the parent dies, the owner of the policy is deemed to be making a gift of all death benefits going to his siblings.  Another potentially catastrophic example of unintended gifting in the context of divorce is illustrated in the following: The client buys a life insurance policy (not subject to a divorce decree) on his own life. He owns the policy and names the mother of his children as beneficiary. He dies. The death benefit is a gift to an unrelated person not protected by an unlimited marital deduction.

Note:  Special attention must also be paid to ownership/beneficiary designations in cases when one of the spouses is not a US citizen.

  1. Ignoring the Formalities

Many of the above issues could be effectively and preemptively addressed through various trust arrangements. It is quite common for a life insurance policy to be owned by an irrevocable life insurance trust (ILIT). The grantor annually gifts the money to the trustee to pay the premiums on the trust owned life insurance policy. However, if the beneficiaries of the trust are not properly informed about their right to withdraw the gifts (Crummey power), or the grantor pays the premiums directly to the insurance company, such “gifts” do not qualify as gifts. As such, the insurance policy may be deemed to be includable in the estate of the grantor. If the grantor happens to go through a divorce at the wrong time, does not follow the formalities of ILIT funding, this might result in bringing the assets of the trust into community estate for valuation purposes.







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