Understanding Community Property Life Insurance

In the US, community property laws refer to assets co-owned by a couple. There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In these states, all assets, income, and debts acquired during a marriage are owned equally by the spouses. This includes life insurance policies, which can be considered community property if the premiums are paid using income earned during the marriage. This is true even if the policy was purchased before the marriage or if only one spouse is named as the beneficiary. If a couple gets divorced in a community property state, all income and assets acquired during the marriage are split equally between them.

Term life insurance and permanent life insurance policies

On the other hand, permanent life insurance is a type of insurance that does not expire and provides coverage for the insured's entire life, as long as they continue to pay the premiums. Permanent life insurance policies include a tax-advantaged cash value feature that increases over time and can be used for borrowing money, withdrawing cash, or paying premiums. The two main types of permanent life insurance are whole life insurance and universal life insurance. Whole life insurance offers a fixed premium payment, death benefit amount, and cash value interest rate, while universal life insurance allows for more flexibility, including the ability to adjust the death benefit and premium payments.

In community property states, such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin, life insurance policies are often considered community property, meaning both spouses have equal ownership of the policy and its benefits. For term life insurance, this means that the entire policy and its benefits are considered community property, and the surviving spouse is entitled to 50% of the benefits, regardless of whether they are the named beneficiary. For permanent life insurance, the benefit is prorated upon the insured's death, and the surviving spouse's entitlement is based on the amount the insured spent on the policy during the marriage.

Community property states

In the US, nine states are known as community-property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In addition, Puerto Rico is a community-property jurisdiction.

In these states, once a couple gets married, they become equally responsible for and have equal claim to everything they own. This includes all assets, income, and debts acquired during the marriage, which are owned equally by the spouses. This can include tangible things like a home, car, boat, and furnishings, as well as retirement accounts, investments, and, in many cases, life insurance.

Any property acquired before marriage can still be owned individually, as can property acquired by gift, inheritance, or bequest from a will, or property acquired in a court award.

In the case of a divorce, assuming there was no prenuptial agreement, the couple must split everything evenly between them. However, spouses can opt out of community property allocation by signing an agreement specifically identifying marital property.

The community property rules can often impact mobile couples without their realizing it. For example, if a couple moves from a community-property state to a non-community property state, their property may still be considered by the Internal Revenue Service (IRS) to be community property unless they take steps to change it.

When it comes to life insurance, if a person lives in a community-property state and income earned during the marriage is used to pay the premiums, the spouse usually has a right to 50% of the death benefit, even if they are not listed as a beneficiary. However, if the premiums are paid with an inheritance, the policy is unlikely to be considered marital property, unless the inherited funds are deposited into and paid from a joint account.

Separate property

In the US, separate property is a category of property that is distinct from community property, community-like property, and quasi-community property. For a single person, the distinction is often straightforward as they do not own community property or quasi-community property. However, for married people or domestic partners, separate property includes all property owned before the current marriage or partnership, as well as property that would be community property if not for a specific agreement. This includes gifts or inheritances received by one spouse, rents and profits generated by separate property, and property acquired with funds owned before the marriage.

In the context of life insurance, separate property refers to policies purchased before marriage or after separation. Life insurance proceeds might be considered separate property if the policy was not owned by the spouse, no premiums were paid by the spouse, there was no contractual right to the proceeds, and no consideration was given for them. However, if life insurance proceeds are comingled with marital assets, they may be considered marital property.

The distinction between separate and community property is important for probate cases, as well as for divorce proceedings and estate planning. In community property states, property accumulated during marriage is generally split equally, while separate property is not subject to the debts or contracts of the owner's spouse.

Community property and divorce

In the United States, there are two systems for dividing property and assets during a divorce: community property and equitable distribution. In community property states, all assets and income acquired during a marriage are considered community property and are split equally between the two parties. In equitable distribution states, on the other hand, assets, earnings, personal property, and debts are divided "fairly" but not always equally.

As of 2024, there are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In these states, all property acquired during a marriage is presumed to be community property, unless it was acquired by gift or inheritance. This includes income, real or personal property, and funds in retirement and savings accounts. Debts taken on during the marriage are also considered community property and will be divided equally.

If a couple divorces in a community property state, all income and assets acquired during the marriage are split equally between the two parties. This is true even if the asset is only in one partner's name. For example, if one partner purchases a house before the marriage, that house is considered separate property and is not subject to division. However, if the same partner purchases a house during the marriage, even if only their name is on the deed, the house is considered community property and will be split equally upon divorce.

In addition to the nine community property states, five other states (Alaska, Florida, Kentucky, South Dakota, and Tennessee) have an opt-in community property law. Registered domestic partners who live in California, Nevada, or Washington are also subject to community property laws.

It is important to note that the existence of a prenuptial agreement will almost always override community property laws and determine the division of property in a divorce.

Community property and federal gross estate

Community property laws affect how you figure your income on your federal income tax return if you are married, live in a community property state or country, and file separate returns. In community property states, life insurance policies are often technically owned by both spouses.

In the case of term life insurance, the entire policy and its benefits are considered community property. This means the surviving spouse would have the right to fifty per cent of the benefits, even if they aren't the named beneficiary. If it's permanent life insurance, such as a whole or universal life insurance policy, the benefit would be prorated when the insured passes away. The amount the surviving spouse is entitled to depends on how much the insured spent on the policy while they were married, and it would be prorated accordingly.

For example, if a couple lives in a community property state and Partner A purchases life insurance two years before marrying Partner B, for the first two years, Partner A uses their own money to pay for the policy. Once they are married, Partner A continues to pay for the policy, but now their income is considered community property. If Partner A dies one year later, with a total of three years paid into the life insurance policy, even if Partner A named someone else as the beneficiary, Partner B would be entitled to half of one-third of the payout, or 16.6%. They are only entitled to half of the prorated amount because the other half still technically belongs to Partner A and will be paid out to the named beneficiary.

The community property rules themselves only go halfway toward understanding how the ownership of life insurance in a community property state impacts an individual’s federal gross estate. Married couples living in a community property state need to understand that only one-half of their interest in community property will be included in their federal gross estates.

For example, if the policy was purchased with community funds and the insured spouse dies, one-half of the proceeds will be included in the insured’s federal gross estate. In the case where the insured dies owning the policy and names their probate estate as the beneficiary, the insured’s executor receives the full amount of the policy proceeds, only one-half of which is includable in the insured’s gross estate. Interestingly, the surviving spouse has a legal claim to one-half of the proceeds under community property principles, since one-half of the proceeds are deemed to belong to them.

A strange result can occur when community funds are used to purchase a policy and the surviving spouse is not made the beneficiary of the full proceeds. In this case, the IRS believes that although one-half of the proceeds are includable in the deceased spouse’s federal gross estate, in certain circumstances, the surviving spouse may have made a gift of that spouse’s half of the proceeds to the named beneficiary.

While this is a curious result, a more difficult question arises on what is included in the decedent’s gross estate where the premiums have been paid with community and separate funds. The answer to this question depends on which state the decedent lived in, because the community property jurisdictions take different approaches.

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