Life insurance can be used as a wealth building tool and a venue to ensure loved ones are financially taken care of in the event of death, as the policy passes to the beneficiary tax free. Before, during, or after a divorce, you may find yourself questioning how to handle your life insurance policy, especially in a community property state like Texas.
There are several types of life insurance policies. Most important is the distinction between a term policy versus a policy with a cash value. With cash value policy, the cash value portion is community property in the state of Texas as it is considered an asset. As a result, the spouse is entitled to half of the cash value accumulated during the marriage. This means that you will likely need to pay out your spouse in the divorce in a surrender of cash value. However, pursuant to IRC §72(e), the rule of “first in, first out” applies. First in, first out, means that the policy owner receives their own investment, or premium paid, in the contract before receiving any gains on the policy. This is important because the principal or basis will not be taxed. This could hurt your financial goals later in life when you must pay taxes on any gains you remove from the life insurance policy. Essentially, your former spouse will be receiving money tax free, whereas you will be paying taxes on any gains you remove later on. Overall, it may be advantageous to consider giving up an asset of similar value rather than paying out half of a life insurance policy with cash value. It should be noted that the IRC §72(e) rule of first in, first out does not apply to annuities.
Conversely, term life insurance policies are simpler. Term life insurance policies contain no cash value and are not considered an asset. The most important factors are who is the beneficiary and who took out the policy, otherwise known as the policy owner. If the policy was taken out by the insured, then the only update needed is a change of beneficiary. If the policy was not taken out by the insured, then the contract of the policy should be consulted to see if the policy should be addressed in the divorce decree when the divorce is finalized.
Additionally, you should update your beneficiary on your life insurance policy if your beneficiary is your former spouse. In your divorce decree, it should also mention changing beneficiaries on any life insurance policy from your former spouse. Many individuals forget to update beneficiaries after a divorce, which is why the divorce decree should also address updating your beneficiary.
In conclusion, life insurance policies can add a layer of complexity to divorce. The Split’s attorneys and financial advisers can assist you with any questions you may have.
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