Insuring for Divorce
Written By: John Klotz1
Is there an epidemic out there? Or does it just seem like everybody and their brother is looking to split with their spouse? And this often occurs following years of marital bliss. So, it’s not surprising that we, as financial advisors, are called upon by various lawyers and clients to set up insurance policies on couples who are splitsville to protect various financial agreements that have been set up. This article will address those insurance needs.
The first part of any insurance discussion involves calculating the risk at hand. In this regard, we need to figure out just what the financial impact on the family would be in the event one of the divorcing spouses dies. Initially, when ascertaining the financial number you put on someone’s life (always an exercise that only an insurance advisor or actuary could find fun), we start with the basics. These basics includes paying for a funeral, final year’s expenses for taxes, education funding for the children, eliminating the mortgage, providing an emergency fund (typically 3 months of salary), providing for a cooling off period following the death of the spouse, and monies for any charities. These are fixed expenses at death.
However, there are ongoing expenses that we need to look at. These include providing the salary of the deceased spouse for a period of time. Depending or not if there are dependent children, this commitment could be for 10 or 20 years, or perhaps a lifetime. When a spouse dies, the ideal situation is to provide between 60 and 80 % of the deceased’s income for this period of time.
Since we are dealing with divorce, this calculation would include child support payments, alimony payments, equalization payments, and any other ancillary features to a divorce agreement. These would ultimately increase the financial commitment required of the deceased in the event of their demise. Often, we come up with a very serious financial commitment required from the estate of the deceased ex-spouse. It often is lopsided if there was a discrepancy in income in the family. For example, if one spouse was a dentist and the other spouse stayed home and raised the children, the dentist spouse would require a greater financial commitment on behalf of his or her estate than the stay at home spouse.
Obviously, if there are dependent children involved, the financial commitment of the estate of the deceased will increase.
We then subtract the assets from this number including stocks, bonds, savings, secondary properties, and other assets. In a happily married couple, there are two assets we do not include in this subtraction process, namely RRSP’s and the principal residence. The reason the RRSP’s are not subtracted as an asset is that they can be rolled tax free to the surviving spouse. With respect to subtracting the home from the calculation, it’s clearly obvious that the surviving spouse and children still need a place to live. It’s bad enough to have a parent die and be forced at the same time to move. Since we are dealing with divorce, there may be two homes, and the deceased spouse could have their home sold to provide for the financial commitments.
Once all our calculations are completed, we typically arrive at a figure that is between 7 and 10 times annual income. So, if we had a spouse earning $100,000 per year, this would result in the estate requiring between $700,000 and $1,000,000 in insurance coverage. And if you think about it, this figure makes sense. If you are earning $100,000 per year and need to provide 70 % of your income for a significant period of time, how much money would you need in the bank to guarantee this amount? 70% of $100,000 is $70,000 per year. Using a 6 % rate of return, you would need $1,166,000 in the bank to guarantee this amount for life.
Once we have determined the amount of coverage required to satisfy the financial commitments to the divorce, we then need to figure out which products are best suited. These programs can range from inexpensive term insurance programs to the more costly permanent insurance programs. Permanent insurance, while more expensive in the short run, provides a level premium that does not increase during your lifetime. You may want to consider this as a solution if your insurance needs go beyond say 20 years. Programs include a Term to 100 insurance products, whereby the insurance premiums stay fixed until age 100.
So, once you have decided on your policy and budget, we need to discuss how the policy is to be set up. One of the issues we have is ownership and beneficiary designations.
Firstly, there is the issue of the beneficiary. Typically, in a divorce, the agreement states that you need to make your ex-spouse the beneficiary of the policy. In the event something happens to you, the ex-spouse receives the proceeds of the insurance policy. And that’s fairly straight forward.
But what about the kids? How do you make sure they receive the monies, especially if they are minors? Ideally, what should take place is some type of joint beneficiary. If you take out a policy for $1 million, 50 % is to be paid to your ex-spouse, the other 50 % is to be paid to your children. But what if your children are minors? How do you make sure they get the money? There are a few ways to do so which vary in tax efficiency and control. Remember, you are dead when the proceeds are paid out.
The most tax efficient way for your kids to receive the monies is to designate them as beneficiaries on your life insurance policy and have the monies held in trust, probably with your ex-spouse as the trustee. The upsides of this beneficiary designation on the policy are that the monies by-pass the estate and avoid probate tax (approximately $15 on every $1000 received) and executor fees (approximately 2 to 5 % of the estate). Because the monies bi-pass the estate, creditors to the estate cannot seize the monies. But there are downsides to this designation. Firstly, your kids need to receive the monies at the age of 18 regardless of their state of mind or maturity. If you’ve as a child the future Doogie Howser, MD, then you know the monies will be spent for education. But what if you’ve got a hell raiser at 18 with his eyes on sleek new Porsche and the tawdry redhead at school? How can you be sure he puts the money aside for education and not for immediate gratification? In this scenario, you can’t. The other downside of this direct designation is there is nothing from stopping the trustee (your ex spouse) from spending all the insurance proceeds by the time the kids are 18. He or she would turn to the kids and state that all the monies have been spent and go ahead, sue me! Now, you are dead, and their closest living relative, namely their remaining spouse, has just screwed them. Now, they have the option of suing their mother or father. It’s so ugly that it’s not even funny.
Another downside of naming the kids directly as beneficiaries with monies to be held in trust, is that if the trustee (your ex spouse) has issues with creditors, there is nothing stopping the creditors from seizing the assets of the insurance policy.
So, what is a divorcing parent to do?
I suggest that you bite the bullet from the tax perspective and make the estate the beneficiary for the kid’s portion. Yes, you have to pay probate tax of $15 on every $1000, and yes, there is an executor fee of 2% to 5 %, but you get to rule from the grave! (Always a plus). And here is what you can say. The children can receive $50,000 when they turn 18 to pay for university. They can receive another $50,000 when they graduate from university, and they can receive the remainder when they turn 30. At the same time, you can leave instructions to the guardian (your ex spouse) that they can use 50% of the insurance proceeds to raise the kids. But they have to leave 50 %in the estate for the kids to fulfill your estate distribution requests.
As a parent, I like this way much better. While it is not as tax efficient, it does put in some controls. And to compensate for the tax issues, you just buy some more insurance.
Finally, there is the issue of the policy ownership on your ex-spouse. Now, what if your ex hooks with a new person? And what if this new person wants your ex to change the beneficiary designation to him or her? Would this not mess up the estate and the issues with the beneficiary designations? Of course it would. The way to prevent this problem is for you to become the owner of the policy on your ex. This will stop them from changing the beneficiary mid stream to the new squeeze as they cannot make this change without the consent of the policy owner (you).
You can also make the beneficiary designation irrevocable, which means that the beneficiary can never be changed. Both achieve the same effect, but there is more flexibility with just owning your ex-spouses policy.
In summary, you should consider all your insurance options before setting up your policies for your divorce settlement. Amounts of coverage, types of coverage, and beneficiary and ownership designations will all be part of these discussions. Best to find yourself a trained advisor who can guide you through the insurance jungle.
This article was written by John Klotz, John is President of Northwood Mortgage Life Insurance Corporation. You can reach John at 416-969-8130 ext. 230 or email email@example.com. You can also listen to John on his bi-weekly broadcast, Money Talks Media (www.MoneyTalksMedia.com).