DIVORCE AND LIFE INSURANCE, QUALIFIED PLANS AND IRAS 2013-2015 I. INTRODUCTION In a divorce, property is generally divided between the spouses. Generally, all assets of the spouses, whether individual, joint, or community, are subject to division. Most states do not require division of property received as a gift or inheritance. An agreement signed before marriage (prenuptial, antenuptial or premarital agreement) can control the division of assets. In addition, in some states, an agreement signed during the marriage can control the division of property. II. INCOME TAX ON PROPERTY TRANSFER A. There is no gain or loss recognized when transferring property: 1. To a spouse or a trust for the benefit of a spouse, or 2. To a former spouse or a trust for the benefit of a former spouse where the transfer is incident to divorce. 1 B. A transfer is incident to divorce if it: 1. Occurs within one year after the termination of the marriage, 2 or 2. Is pursuant to a divorce or separation instrument and occurs within six years after the termination of the marriage. 3 C. If no gain or loss is recognized, the transfer is treated as a gift and basis is carried over, whether the fair market value is more or less than basis. 4 Example: Pursuant to a divorce, Katie transfers her half interest in a jointly owned house to former spouse Tom in exchange for a $100,000 payment from Tom. The fair market value of the house is $250,000 and the basis in the house is $200,000. Katie s transfer of the half interest is treated as a gift to Tom, and Tom s transfer of $100,000 is treated as a gift to Katie. There is no gift or income tax 1 1041(a). 2 1041(c). 3 Temp. Treas. Reg. 1.1041-1T(b), A-7. 4 1041(b). 1
recognized, and Tom s carryover basis in Katie s half interest in the house is $100,000. Example. Pursuant to a divorce, Tom transfers stock with basis of $90,000 and value of $80,000 to his former spouse Katie. Tom cannot deduct the loss and Katie s basis is $90,000. Katie later sells the stock for $75,000. Subject to other restrictions on deductibility, Katie may recognize a loss of $15,000. 5 D. The nonrecognition of gain rule applies even when property is subject to liabilities in excess of basis. 6 Example: Tom owns property with fair market value of $10,000, with basis of $1,000, subject to a loan of $5,000. He transfers it to Katie pursuant to a divorce. Tom recognizes no income. Katie s basis in the property is $1,000. E. However, gain is recognized on transfers if (i) the transfer is in trust and (ii) liabilities exceed basis. 7 Any gain recognized is added to the transferee s carryover basis in the asset transferred. 8 Example: Tom owns property with fair market value of $10,000, with basis of $1,000 subject to a loan of $5,000. Tom transfers it to a trust for Katie pursuant to a divorce. Tom recognizes income of $4,000. Katie s basis in the property is $5,000. F. The transferee of any carryover basis property includes in his or her holding period the period during which the transferor spouse held the property. 9 G. The nonrecognition rule does not apply where the spouse or former spouse is a nonresident alien. 10 H. A transferor must provide to the transferee records sufficient to determine the adjusted basis and holding period of the property as of the transfer date. 11 III. GIFT TAX ON PROPERTY TRANSFER A. Generally, transfers pursuant to divorce decrees are not taxable as gifts because they are deemed to be made for full and adequate consideration. 12 5 E.g., 1211(b) limits on capital losses may limit Katie s deduction. 6 Temp. Treas. Reg. 1.1041-1T(d), A-12. 7 1041(e). 8 Id. 9 1223(2). 10 1041(d). 11 Temp. Treas. Reg. 1.1041-1T(e), A-14. 12 See Rev. Rul. 68-379, 1968-2 C.B. 414. 2
B. Transfers pursuant to written property settlement agreements are not taxable as gifts provided: 13 1. The transfer must be for settlement of marital or property rights, or to provide for support of a minor child of the marriage, and 2. The final divorce decree must occur within one year before the property settlement agreement or within two years after the agreement. IV. ALIMONY AND CHILD SUPPORT A. In addition to property transfers, a divorce decree may require that one spouse pay alimony (also known as maintenance) and/or child support. Alimony and maintenance payments are generally taxable to the recipient and deductible by the payer. 14 To receive this tax treatment alimony or maintenance payments must meet the following requirements: 1. Payment must be pursuant to a divorce or separation instrument; 2. The divorce or separation instrument must not designate such payment as not includible or deductible as alimony; 3. Payment must be in cash; 4. The payer and payee are not members of the same household when the payment is made; and 5. There is no liability to continue the payments after the recipient s death. 15 B. In contrast to alimony, payments for child support are not deductible by the payer and are not taxable to the payee. 16 V. LIFE INSURANCE A. Life insurance often plays a key role in a divorce. 1. Life insurance can help equalize property distribution. A divorce decree can require that one former spouse own life insurance insuring the life of the other former spouse. 13 2516. 14 71(a), 215(a). 15 71(b)(1). 16 71(c). 3
2. Life insurance can be used to protect the loss of alimony payments. A divorce decree can require that an insured former spouse name the other former spouse as the beneficiary of life insurance that s owned by the insured. Alternatively, a divorce decree can require that the insured former spouse pay the premiums on life insurance owned by the other former spouse. 3. Life insurance can be used to protect the loss of child support payments. A divorce decree can require that the children or a trust for the benefit of the children be named as beneficiaries of life insurance. B. A divorce decree should specify who is to be the owner, beneficiary, and payer of a life insurance policy. 1. If the divorce decree is already final, simply comply with the decree. 2. If the divorce decree is not yet final, consider: a) Who should be the owner? Possibilities include the insured, the former spouse, or a trust. b) Will there be a change of ownership upon a future event, such as remarriage or a beneficiary reaching the age of majority? c) Will there be any restrictions on access to the policy cash (loans, dividends in cash, full surrender, partial surrender, exercise of settlement options, etc.)? d) Who will pay premiums? Should proof of payment be provided to a former spouse? e) Who will be beneficiary? If the beneficiary designation simply reads, children until majority, what happens when one child reaches majority and another has not yet? f) Does a minor have to be named as beneficiary of entire policy? g) If children are to be beneficiaries, consider having the divorce decree include children or a trust for their benefit in order to create the opportunity for flexible planning. h) Will the beneficiary designation be irrevocable? If not, should proof of the designation be provided to the former spouse? 4
i) If the policy owner is the insured, the divorce decree can require that the beneficiary be the former spouse, the children, or a trust for the former spouse and/or children, or any combination of these possibilities. The decree might require that the designation be irrevocable. If not required, the designation should be revocable. 3. The insurance company generally will pay a death benefit only to the person listed as the beneficiary on the insurance company s records, regardless of the policy owner s intent to name a different beneficiary and regardless of the divorce decree. If the policy owner did not change the beneficiary to comply with the divorce decree, it is then up to the intended beneficiary to seek court remedies. 4. State law may revoke a spousal beneficiary designation upon divorce. 17 If a policy is part of a company plan subject to ERISA however, federal law may supersede such state statutes. 18 It is important that beneficiary designations be updated following a divorce. 5. A divorce decree can require that one former spouse pay the premiums on a policy owned by the other spouse. As long as the payer is not required to pay premiums after the policy owner s death, this payment is treated as alimony. 19 Even if a divorce decree requires one former spouse to pay a third party on behalf of the other former spouse the payment can still be treated as alimony, as long as all other alimony qualifications are met. 20 Example: Tom owns a policy on Katie s life. The divorce decree requires that Katie pay the annual premium of $5,000 on this policy. Assuming that all alimony qualifications are met, the $5,000 paid by Katie to Tom is alimony. This payment is income tax deductible by Katie and taxable income to Tom. C. Insurance companies are generally allowed to release information regarding a policy only to the policy owner. If the policy owner has consented in writing to the release of information to a former spouse, the insurance company is able to provide policy information to the former spouse. D. If the policy owner is not the insured, then the owner should also be the beneficiary. Otherwise, if the beneficiary is someone other than the policy owner, then upon the insured s death, the policy owner is considered to be making a gift 17 See e.g. Ohio Revised Code 5815.33; Colo. Rev. Stat. 15-11-804; Mich. Comp. Laws Ann. 552.101; Tex. Fam. Code Ann. 3.632(a)-(c); Va. Code Ann. 20-111.1; Wash. Code Ann. 11.07.010. 18 See Egelhoff v. Egelhoff, 532 U.S. 141 (2001); Hillman v. Maretta, U.S. No. 11-1221 (2013). 19 71(b)(1)(D) and Treas. Reg. 1.71-1T, Q&A 6. 20 71 and 215; Treas. Reg. 1.71-1T. 5
of the death benefit amount to the beneficiary. If the death benefit is more than the policy owner s annual exclusion amount and gift tax exemption, the policy owner will owe gift tax. Example: Tom owns a policy on Katie s life with death benefit of $1 million. The children are named as beneficiaries. When Katie dies, the death benefit is treated as a gift of $1 million from Tom to his children. This gift uses part of Tom s lifetime gift exemption and also reduces his estate exemption. If Tom has previously fully used his gift exemption he will owe gift taxes. E. A life insurance policy, as well as funds to pay for the premiums, can be transferred to an irrevocable trust. These transfers are considered transfers to the trust beneficiaries. If the trust beneficiaries are the former spouse and/or minor children of the marriage, the transfer is not considered a gift if it is made pursuant to a written agreement for property settlement or reasonable support and divorce occurs within one year before or two years after the agreement. 21 F. Transferring a life insurance policy pursuant to a divorce is generally income tax free, regardless of whether it is individually or jointly owned, its value is more than, equal to, or less than basis, or there is a policy loan greater than basis. 22 G. However, income is recognized if a policy with a loan greater than basis is transferred to a trust for the benefit of a spouse or a former spouse. 23 When life insurance with a loan greater than basis is transferred to a trust, this generally will result in taxable income and a triggering of the transfer for value rule. 24 Example: Tom owns a policy on his life. Pursuant to a divorce decree, he transfers ownership of the policy to a trust for Katie, his former wife. The policy has gross cash value of $75,000, a policy loan of $50,000, and basis of $30,000. Tom recognizes $20,000 of taxable income (the loan of $50,000 less basis of $30,000). The trust has a new basis of $50,000. H. Death benefit is income taxable if a life insurance policy is transferred for valuable consideration unless one the following exceptions apply: 25 1. Transfer to the insured, 2. Transfer to a partner of the insured, 21 2516. 22 1041; Temporary Treas. Reg. 1.1041-1T(d). 23 1041(e). 24 101 and 1001. 25 101(a)(2). 6
3. Transfer to a partnership in which the insured is a partner, 4. Transfer to a corporation in which the insured is an officer or shareholder, or 5. The basis in the hands of the transferee is determined by reference to the basis of the transferor. A policy transferred pursuant to a divorce meets the fifth exception (basis carried over) if no gain or loss is recognized on the transfer. Example: Tom owns a policy on his life. Pursuant to a divorce decree, he transfers ownership of the policy to a trust for Katie, his former wife. The policy has gross cash value of $75,000 and basis of $30,000. Tom recognizes no income on the transfer and the trust has carryover basis of $30,000. The death benefit remains income tax free because of the basis exception to the transfer for value rule. I. However, if a transfer triggers gain or loss because a policy with a loan in excess of basis is transferred to a trust, the transferee s basis is adjusted to reflect the gain recognized by the transferor. 26 Accordingly, basis does not carry over from the transferor to the transferee and the fifth exception does not apply. Therefore, unless another exception applies (such as the transferee trust is a partner of the insured), the death benefit becomes income taxable. Example: Tom owns a policy on his life. Pursuant to a divorce decree, he transfers ownership of the policy to a trust for Katie, his former wife. The policy has gross cash value of $75,000, a policy loan of $50,000, and basis of $30,000. Tom recognizes $20,000 of taxable income (the loan of $50,000 less basis of $30,000). The trust has a new basis of $50,000. Unless the trust is a grantor trust or a partner of Tom, the death benefit will be subject to income tax. J. Many insurance companies will exchange second-to-die policies for two single life policies (one on each former spouse). Often this is without additional underwriting, but sometimes not. Either way, this does not qualify as a tax-free 1035 exchange. 27 The owner of the second-to-die policy (e.g., an irrevocable trust) reports any gain as taxable income. K. The death benefit of a policy owned by an insured is in the owner s gross estate. 28 If the divorce decree requires that the policy owner name the former spouse as the beneficiary, then the amount of the death benefit paid to the former 26 1041(e). 27 See Private Letter Ruling 9542037 (Oct. 20, 1995). 28 2042. 7
spouse is deductible on the estate tax return as a debt or claim. 29 If the divorce decree requires the policy owner to name the children as the beneficiaries, then the amount paid to the children that is within the state support requirements or is for full and adequate consideration is deductible as a debt or claim. 30 I. If an insured dies within three years of transferring a life insurance policy to a former spouse, there is no estate inclusion if the transfer is deemed to be for full and adequate consideration as opposed to a gift. 31 J. Considerations for policies owned in an irrevocable trust at the time of the divorce: 1. The policy should not be the subject of property division since it is not owned by either spouse. 2. Similarly, the beneficiary designation of a policy in an irrevocable trust at the time of the divorce should not be the subject of a divorce decree. 3. Nonetheless, a divorce decree can require that one or both former spouses continue to pay premiums on a life insurance policy owned by an irrevocable trust. 4. An irrevocable trust may provide that a spouse who is a trustee or trust beneficiary will cease being so upon divorce. If the trust document does not address the divorce situation, then state law might provide a course of action to obtain these results. K. Northwestern Mutual (NM) procedures regarding life insurance in divorce include the following: 1. The policy owner is responsible for complying with any divorce decree or obligation. 2. While control of the policy remains with the titled policy owner, if a non-owner asserts an interest in the policy as a result of a court order, NM will restrict the policy according to the terms of the order. 3. A non-owner can assert an interest in the policy by submitting a copy of the court order to NM or to an NM Financial Representative. 4. A restriction consistent with the court order is prepared for the policy owner s signature. 29 2053(a)(3), (4); Rev. Rul. 76-113, 1976-1 C.B. 276. 30 Rev. Rul. 78-379, 1978-2 C.B. 238. 31 2516. 8
5. If restricted, actions that the policy owner wishes to take with regard to the policy can require consent by the non-owner. VI. NON QUALIFIED ANNUITIES A. Normally a transfer of an annuity between unrelated parties triggers income tax on any gain in the annuity. 32 This acceleration of gain rule does not apply to transfers made to a spouse or former spouse incident to divorce. 33 B. A transfer of property such as an annuity contract or life insurance contract does not constitute alimony because it is not paid in cash. Therefore there is no income tax deduction for the transferor and no taxable income for the transferee. 34 C. An annuity contract transferred to a former spouse retains the transferor s basis, and annuity payments received by the recipient are part tax free return of basis and part taxable income. 35 D. Where there is no transfer, but an individual owns an annuity and then makes periodic payments to a former spouse as alimony, the owner of the annuity is taxed on each annuity payment under the normal exclusion rule, and the full payment to the former spouse is deductible by the payer and taxable to the recipient as alimony. 36 VII. NONQUALIFIED DEFERRED COMPENSATION A. Divorce settlements requiring transfer of rights to nonqualified deferred compensation do not trigger immediate income taxation. 37 The former spouse who receives the deferred compensation is taxed upon receipt. Example. Tom has $380,000 in a deferred compensation account through his employer. Pursuant to a divorce he transfers rights to $190,000 to his former spouse Katie. Tom is not taxed on this transfer. When Katie receives the deferred compensation she will be subject to ordinary income tax. B. Nonqualified deferred compensation remains subject to FICA taxes to the same extent as if the rights to the deferred compensation had been retained by the employee spouse. The FICA tax is deducted from the payment to the nonemployee spouse. 38 32 72(E)(4)(C). 33 72(E)(4)(C)(ii), 1041(a). 34 See Private Letter Ruling 200536014 (Sept. 9, 2005). 35 See General Explanation of the Deficit Reduction Act of 1984, at p. 711. 36 72, 215. 37 Rev. Rul. 2002-22, 2002-1 C.B. 849. 38 Rev. Rul. 2004-60, 2004-1 C.B. 1051. See also Private Letter Ruling 200646003 (Nov. 17, 2006). 9
C. Generally accelerated distributions from nonqualified deferred compensation plans are not permissible under section 409A, but an exception allows for distribution due to a domestic relations order. 39 D. If an individual pays a former spouse to buy out future deferred compensation payments, the transfer is treated as a nontaxable event under 1041. 40 VIII. QUALIFIED PLAN A. Transferring qualified plan assets to a spouse, former spouse or dependents is not treated as a taxable distribution if the transfer is required by a qualified domestic relations order (QDRO). 41 Absent a QDRO, a voluntary partition of qualified assets is taxable. 42 B. A QDRO is a judgment, decree or order (including judicial approval of a property settlement agreement) used to transfer or assign rights in a qualified plan to an alternate payee such as a child, dependent or former spouse. A QDRO must meet the following requirements: 1. It must related to the provision of child support, alimony, or property rights; 2. It must be made under a state s community property or other domestic relations law; 3. It must create, recognize or assign the right to receive all or a portion of a participant s qualified plan benefits; 4. It must clearly specify who is entitled to receive benefits, the amount or percentage to be paid, the number of payments or period to which the order applies, and the plan(s) to which the order applies; and 5. It may not require the plan to provide (i) a benefit not otherwise provided under the plan, (ii) an increased benefit, or (iii) a benefit that is required under another previously ordered QDRO. 43 C. A plan administrator is required to determine if an order is a QDRO. 44 39 See Treas. Regs. 1.409A-3(i)(2)(i), 1.409A-3(j)(4)(ii); 414(p)(1)(B). 40 Private Letter Ruling 200442003 (Oct. 15, 2004). 41 401(a)(13), 414(p). 42 See Private Letter Ruling 8735032 (June 2, 1987); Gallade v. Comm., 106 T.C. 355 (1996). 43 414(p)(1). 44 414(p)(6). 10
D. A former spouse who receives qualified plan distributions pursuant to a QDRO is taxed on distributions from the qualified plan as if he or she were the participant. 45 A former spouse has the option of rolling the distribution over and delaying tax until later distributions are made. 46 E. If the alternate payee is a child or a dependent, the participant remains the distributee and is taxed on distributions from the qualified plan to the alternate payee. 47 F. The 10% early withdrawal penalty does not apply to a distribution to an alternate payee pursuant to a QDRO. 48 IX. IRA A. An individual retirement account (IRA) is not a qualified plan; thus, QDROs do not apply to IRAs. B. The transfer of an interest in an IRA to a former spouse pursuant to an appropriate divorce or separation instrument does not result in taxation. 49 The IRA is then maintained for the benefit of the former spouse. C. In order for a transfer to be non taxable, parties must make sure that the transfer is a documented requirement of a divorce, otherwise it may be deemed a taxable distribution. 50 45 402(e)(1)(A). 46 402(e)(1)(B). 47 402(a); Notice 89-25, 1989-1 C.B. 662. 48 72(t)(2)(C). 49 408(d)(6), 71(b)(2)(A). 50 See, e.g., Czepiel v. Comm., TC Memo 1999-289 (divorce judgment did not specify that required asset transfer come from IRA); Jones v. Comm., TC Memo 2000-219 (husband received IRA distribution check then endorsed check to divorcing spouse); Private Letter Ruling 9422060 (Mar. 14, 1994) (transfer of IRA balance to spouse not incident to divorce); Private Letter Ruling 8820086 (Feb. 25, 1988) (transfer of IRA balance to spouse not incident to divorce); Private Letter Ruling 9344027 (Aug. 9, 1993) (transfer of IRA as part of private separation agreement deemed taxable). 11
This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements. This information was compiled by the advanced planning attorneys of The Northwestern Mutual Life Insurance Company. It is intended solely for the information and education of Northwestern Mutual Financial Representatives and advisors with whom they work. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Northwestern Mutual and its Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions. To comply with Circular 230 Copyright 2013 by The Northwestern Mutual Life Insurance Company, Milwaukee, WI 12
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