Beneficiary Designation and Divorce
David purchased a $1,000,000 whole life policy 10 years ago and named his wife, Sarah, as primary beneficiary and his estate as contingent beneficiary. David and Sarah divorced 3 years ago. David never updated the beneficiary designation. David remarried last year to Lisa. David dies unexpectedly. Sarah claims the death benefit, but Lisa contests, arguing that divorce should revoke the designation. The policy is subject to state law that follows the substantial compliance rule and has no automatic revocation upon divorce statute. The policy cash value is $200,000, and David's estate is worth $500,000.
1. Who is entitled to the death benefit? Explain.
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Under the substantial compliance rule and absent a state statute automatically revoking beneficiary designations upon divorce, the insurer must follow the beneficiary designation as written. Sarah is the named primary beneficiary, and David never changed it. Therefore, Sarah is legally entitled to the $1,000,000 death benefit. Lisa's contest would likely fail unless she can prove David intended to change the beneficiary or that state law specifically revokes designations upon divorce. The contingent beneficiary (estate) would only receive proceeds if Sarah had predeceased David. Thus, the insurer should pay Sarah.
2. What are the tax consequences for Sarah and for David's estate?
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Sarah receives the $1,000,000 death benefit free of federal income tax under IRC §101(a). However, if the policy had been transferred for value or if Sarah is not the insured, different rules might apply, but here Sarah is the beneficiary and the insured is David, so the death benefit is income-tax-free. The estate does not receive the proceeds, so it is not included in David's gross estate for estate tax purposes (assuming David did not own the policy at death? Actually, David owned the policy, so the proceeds are included in his estate if he had incidents of ownership. But since Sarah is the beneficiary, the proceeds are included in David's gross estate under IRC §2042 because he owned the policy. However, the unlimited marital deduction does not apply because Sarah is ex-spouse. So the $1,000,000 is included in David's taxable estate, potentially creating estate tax liability if the estate exceeds the exclusion. The estate's worth of $500,000 plus $1,000,000 = $1,500,000, which is below the 2025 federal exclusion of $13.99 million, so no federal estate tax. State estate tax may apply. Sarah receives no income tax. The estate may have to pay estate tax if applicable, but likely not federally.