EP 207: How Life Insurance Works in Divorce

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One of the questions that comes up often that is a source of confusion, is how does life insurance work during the divorce process and actually afterwards. I want to take some time and clarify how it could work and how it might apply to you. I’m going to start with how it works during the divorce process. Then also talk about the role after the divorce process because it’s not always intuitive and it’s usually not what people think. The first element is, during divorce the question that people ask, is life insurance something that’s split or how does that work? Does it have value? Generally speaking, it depends on what kind of life insurance policy you have. Most life insurance policies, not all, but most life insurance policies are what’s called term life insurance, which is a policy that exists for a certain term or certain number of years.

You buy this life insurance policy. It may be for 20 years and you pay a monthly amount and if you were to pass away during that time, then that life insurance policy pays out. But after that time frame passes, that money goes away and you don’t get it back and that life insurance policy doesn’t have any value. Conversely, some life insurance policies are called whole life policies which are just that. There are many complications and variations within them, but they cover your whole life. They don’t have a term, they don’t have an ending date. What’s important about whole life policies is that oftentimes whole life policies build up what’s called a cash value. That cash value is the case or the place where when you build up that policy, there is some value to it that you can cash out or borrow against or sell the policy for, that has value associated with it.

The real goal is, is to figure out, well what type of life insurance policy do you have and does it have any value. Now, term policies generally speaking, have zero value to them. If you’re thinking about your financial information or you’re splitting up your assets or whatever, oftentimes you’ll see the life insurance policy and you’ll put the value. You’ll need to list that you have the life insurance policy, but the value on it might be zero. So there’s nothing to discuss or at least to split when it comes to the policy itself. That’s most common with term policies and, just as an aside, is the reason that term policies are so common, is because they don’t have a value at the end, they tend to be cheaper. Term policies tend to be less expensive for people then the whole life policies and just more common and simpler.

I just see them a lot more often and I think they’re more popular than the whole life policies. It’s just something you should be aware of but nothing to worry about there. Just want to make sure that you understand why it doesn’t have any value in why it’s so common. Then also if you have a whole life policy. So the question I’ll ask is if you have a whole life policy and you’re trying to split things during divorce, my question to you will be, well, what is that policy worth? What’s the cash value on that policy? If there is a cash value to the policy, then that is an asset that needs to be split and needs to be discussed. Usually you don’t physically split a life insurance policy, but the person who owns it, that goes on their side of the ledger and then the person who doesn’t own that life insurance policy gets their share of the value from it, usually from some other asset.

Rarely do you actually take the cash out from the life insurance policy. It is an option and there’s lots of intricacies and complications to it, but we’re not gonna go through it cause it’s just so minute and varies so often. But it is an asset, no different than a retirement account or a bank account or a valuable or collectible or whatever is. It has value and therefore it is something whose value you need to determine who’s going to keep and what someone else is going to get in exchange for that life insurance policy. Now, the other side of the equation is after divorce, how does life insurance work? It’s something that’s interesting because oftentimes I’ll hear from you, you’ll say like, “Hey, my spouse is requiring me to get a life insurance policy. Does that make sense? Why am I getting a life insurance policy that my spouse owns or my spouse is the beneficiary of or whatever?”.

Some cases, I’ll tell you also like, “Hey, you should require that your spouse gets a life insurance policy”, or I should say soon to be ex-spouse, “gets a life insurance policy because it can be effective for you.” Here is the scenario. Why does that matter? Well, what matters is that if there are ongoing support payments, and they could be alimony/spousal support or they could be child support payments. If they’re ongoing payments, then you may want to have an insurance arrangement … I also include disability insurance. We’re just talking life insurance for the moment … to secure the spousal support or the child support payments. What do I mean? Well, I’m going to give you a very common scenario and I’m gonna try and keep the math very simple so you understand, and I can illustrate the point very clearly for you.

Let’s just say you and your spouse have come to a settlement and your spouse owes you $1,000 a month in support … Doesn’t really matter what kind of support … over five years. So $1,000 a month over five years. So after one year, that’s $12,000 of support. In five years that’s $60,000 total support that you’re going to be owed. Well, what happens if your spouse were to pass away during that time? Well, if that were the case and you didn’t have any kind of insurance, you would just be out of money. You would just stop getting those payments and you would have no way to get those funds that you were owed. Or, at least, it would be very difficult to get those funds that you are owed because there was no insurance set up that you owned and that could be devastating to your life.

Now, I use the example of 1,000 a month, but sometimes it’s 3,000 a month or 5,000 a month or whatever the case may be or more. If you don’t have life insurance to cover that, that can cause real harm to you if the unforeseen were to happen. Now, the element or what you would do is, so you have $1,000 a month for five years, so $60,000 of support payments coming in. What you would say is, “Hey, spouse, you need to get a life insurance policy with a total amount of $60,000 of coverage so if something were to happen to you, some unfortunate circumstance would happen to you, that I, the person receiving support, am not left out in the dust and finding myself broke all of a sudden because of your passing.” If that person did pass away, you would get a check for $60,000 which would cover all of your support payments that are outstanding.

Or to take it another direction, if you’re the person paying the support, someone may request of you to get a life insurance policy for all the outstanding support payments just to make sure that if something were to happen, that those support payments don’t just disappear, but that person receives the support that you had agreed to. Now, it gets a little bit more complicated because there are a couple things that we have to think about. One is, who owns the policy and two is, can we adjust that policy down the line? What do I mean? Well, the first is who owns the policy. One of the things that’s very tricky is if one person is the owner of a life insurance policy. You can’t just call up the life insurance firm after your divorce and say, “Hey, does my ex-spouse still have that life insurance policy?”

No. And that ex-spouse might say, “Hey, I don’t feel like paying for this policy anymore” and just stop paying it. If the worst case scenario were to happen, then you’d be in a position where they stop paying for the policy so the policy lapses. If they were to pass away, you don’t get any money. One of the things that people write into the agreement is either the spouse receiving the policy is the owner or there’s some sort of verification so that you can check in at least once a year, but usually more often than that, to make sure that the life insurance policy is still current and it is acceptable and everything is going on. The spouse that has the policy is required to provide verification anytime it’s requested, at least annually, just to make sure that nothing goes missing.

Now, if you’re the person paying the policy, if you’re the one who’s like, “Well, I’m already paying all the support and I have to pay for a policy on top of that, that doesn’t seem fair to me.” And I understand the concern. I’m not gonna make a judgment one way if it’s right or wrong. My job is just to help people set up their financial picture in the best way possible. One of the things I would suggest, particularly if you’re concerned about that, is to reduce the life insurance policy amount every year. What does that mean? Well, one of the ways to reduce your life insurance bill, and makes plenty of sense for me and whenever you see the scenarios is, let’s go back to our scenario of $1,000 a month for five years. That’s $60,000 total. Let’s just keep the math very simple.

Let’s just say one year has passed. Then there’s only $48,000 cause you’re paying 12,000 a year. One year has passed. There’s four years of support left at $1,000 a month. That’s 12,000 a year times four years or $48,000 of support payments are outstanding. But you took out a life insurance policy for $60,000. What you could do is say, “Hey, every year I’m going to reduce my life insurance policy amount by the amount of support that’s outstanding.” So instead of carrying $60,000 of life insurance, after one year you only have to carry 48,000. Then the next year you only have to carry 36,000 and then the next year 24, the next year 12 and then you’re done. The reason you would do that is the lower the amount of life insurance coverage that you have, the cheaper your monthly premiums are going to be.

I see something very often, or at least I encourage people who have enough foresight to think about this kind of thing, is to say, “Hey, here’s a way that we can reduce your burden”, and there’s no reason if you’re the ex-spouse who’s receiving support, you would have any issue with them declining the coverage or reducing the amount of coverage by the total outstanding support amount, because you still one way or another are going to get all the money that you had agreed upon. Now, it does potentially get complicated and it’s something you have to stay on top of and you have to do the calculations, but it’s certainly something that you can write into the divorce decree. It’s something that you can negotiate in advance and there’s no issue, no reason, that you shouldn’t be able to reduce the amount of life insurance that you have for the outstanding support each year.

Another thing that I bring up, and this one is sensitive to state laws and also who’s very savvy, and that is who’s paying for the life insurance policy. Sometimes I’ll say, ‘Hey,’ depending upon who’s asking and what the scenario is and what the individual circumstances are. If one person wants a life insurance policy, the other person doesn’t, or if it doesn’t come up, you can split the cost. Split the cost of the premiums so that you’re both sharing in it and it’s something that you can, so you’ll know exactly that it’s getting paid every month, you’re both sharing it and it doesn’t feel like an unnecessary burden to either party.

The after-divorce scenario has a lot more moving parts to it, but I just went through them quickly so that you can understand what types of things that you should be thinking about when it comes to life insurance. A quick summary. During divorce, whole life policies generally have a cash value in which case you will need to split that and that’s an important asset. Term policies generally don’t have any value to them and therefore, although you need to declare them or disclose them, they don’t really have a value that you split. Then after divorce, life insurance is often times used to secure a settlement for the outstanding support payments. If the unforeseen were to happen, the person who has potentially many years of support still supposed to be coming to them, that support is not interrupted by a spouse’s passing.

One last minor point to that, because I went through a lot of very moving parts on that quickly. The other moving part is if you’re really savvy and you really want to push for it, you can also get disability insurance as well for that same scenario of after divorce. Not just what if one spouse passes away, but what if that one spouse becomes disabled and still owes you a bunch of spousal support payments? You can’t necessarily expect them to be able to pay for your life if they’re disabled and can’t work. Disability insurance is another way, very similar to life insurance in terms of the mechanics, that you could set that up for your future and protect yourself if there are outstanding support payments.

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