When it comes to Life Insurance and Property Settlements, Spouses Beware!

Not long ago, I received a question from an adviser. The adviser  had a client who routinely prepared her own tax returns. She had telephoned the adviser because she had received a Form 1099-R from Podunk Mutual Life Insurance Company. The Form 1099 included a gross distribution of $190,000, and the taxable amount was $147,000. The client said she had not received a check and was wondering why she had received a form 1099-R.

In 1976 her former husband purchased a whole life insurance policy with a death benefit of $145,000. He was the insured and the owner of the policy. Over the years, he borrowed against the life insurance policy for a variety of reasons. In 2001, the couple divorced. As a result of the property settlement, the former husband transferred ownership of the life insurance policy to her.

Over the course of time, her former husband stopped making premium payments. The policy borrowed against itself to make those payments. This election is called the “Automatic Premium Loan Provision.” Interest due on the loan was also not paid by the former husband. It continued to accrue and was capitalized into the loan.

Recently, the interest could no longer be capitalized, and the policy loan – $184,000 – exceeded the policy cash values. This client was asked to make a premium payment. That premium was $16,000 and she did not have the financial resources to make the payment. However, she did receive a letter from Podunk Mutual explaining that the “policy would be terminated due to an excess loan situation” meaning that she would receive the 1099-R.

This is clearly a case of “phantom income.” The life insurance policy was “over loaned” and lapsed for non-payment of premium. Generally, a loan taken from a life insurance policy is not includable in the policy holder’s income at the time of the loan. It is not treated as a taxable distribution. However, if a loan is outstanding when a life insurance policy lapses, the loan amount is added to the cash value for purposes of calculating the gain in the contract. The gain is equal to the excess of total cash value over the basis and is taxable as if the owner had actually received the cash in the transaction.

Sadly, this client received poor counsel with regards to receiving this type of property distribution in her divorce. Spouses beware: if there is a loan against the life insurance policy, do not accept the insurance contract as part of property settlement.

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