Divorce can be one of the most financially devastating events in a person’s life. Legal fees, lost assets and bankruptcies often result from this occurrence, and some assets may need to be sold at below-market costs to divide the proceeds. Divorcees who own annuity contracts usually discover that dividing this asset can be a very messy — and costly — process.

Here’s what your clients need to know when it comes to handling annuities in a divorce case. (For related reading, see: Understanding Regulations on Qualified Longevity Annuity Contracts.)

Key Issues to Know

The first thing to understand when it comes to dividing an annuity contract via court order is that doing so is a real bureaucratic headache for the insurance company. For this reason, many of them will simply take a partial distribution from the present contract and create a new contract with the proceeds. But this course of action can present several disadvantages to the current contract holder(s):

  • Tax issues: If the divorce decree does not mandate that the division of the contract be a tax-free event, then the distribution may be coded as a normal distribution and subject to tax and penalty if applicable.
  • Living and death benefits: A substantial withdrawal from the annuity contract will be considered an excess withdrawal and will reduce any living and/or death benefits that are paid from the contract.
  • Surrender charges: If the annuity carrier processes the division of the contract as a withdrawal, then any outstanding surrender charges may be assessed against the withdrawal, leaving the receiving spouse with less than half of the contract value. A withdrawal of half of the contract value will always exceed the amount that the contract holder can withdraw without penalty, and the excess amount will be penalized accordingly.
  • Product differentiation: The receiving spouse may be put into a new product that has different (and, in the current market environment, less competitive) features than the previous contract. For example, most annuity contracts issued between 2003 and 2008 had better guarantees than current contracts. Therefore a recipient of a division of one of these contracts will likely not get as good a deal as they had before. (For more, see: How to Manage Your Finances Through a Divorce.)

Minimizing the Downside

Here’s what advisors can do to minimize the disadvantages of dividing annuity contracts between ex-spouses. Taking these steps can benefit the client, the advisor and the divorce attorney.

  • Find out from the annuity carrier how it handles the division of a contract for divorces: This is not likely to be a question that customer service phone reps get that often, so be prepared to talk to someone in their legal department about this. Be sure to get this answer in writing, and also do this before the insurance company gets the court order, because this will give you a chance to add to or change the wording in the divorce decree to ensure a tax-free division if necessary.
  • Divide the marital assets using other assets: If possible, try to get the spouses to agree to let one spouse keep the entire annuity contract and give the other spouse something else of equal value. This can effectively head off all possible contract division disadvantages at the pass.
  • Divide assets using whole contracts: If the divorcing spouses owned three annuity contracts, let one spouse keep the largest one and give the other two to the other spouse. Rectify any remaining inequality with other assets. It is always easier to divide most other types of assets — except, of course, tangible real property. (For more, see: How to Protect Your Retirement After a Divorce.)

Here are some other factors to consider when dividing whole or partial contracts in order to maintain equality:

  • Age of the contract: Older contracts may have better living and death benefit riders, and their surrender charge schedules may have expired. A contract with no surrender charges is always better than one with them.
  • Living and death benefit values and features: A contract where the living and death benefits substantially exceed the current contract value is worth more than its face amount. Be sure to take this into account if the contract needs to be divided.
  • Cost basis: A contract that is worth three times the amount of its initial premium will generate much more taxable income than a contract that has only grown by 20%. Contracts with a higher cost basis are more valuable from a tax perspective than those that have grown more.
  • Guaranteed contract interest rates: Some variable contracts have a savings account in them that pays a higher rate of interest than can be found elsewhere. This feature adds additional value to the contract.

The Bottom Line

Annuities are complex instruments and can be difficult to divide equitably in a divorce. Advisors need to be sure to carefully examine each contract in order to determine the best course of action. Doing so can help to ease the divorce process and save time and money for all concerned. (For related reading, see: 3 Life Events That Can Ruin Retirement Plans.)

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.