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Life insurance tax surprise: The unholy trinity

A major plus with life insurance is that the death benefit is usually tax-free. Your beneficiaries receive the money and don't have to worry about a cut going to Uncle Sam.

But there's an exception you should know about if you're planning to buy life insurance and want to protect yourself from a gift tax.

The tax trap is known as the "unholy trinity" or "the Goodman Triangle" after a 1946 court case, Goodman v. Commissioner of the Internal Revenue Service. It happens when three different people play the roles of policy owner, insured and beneficiary.

Think of a life insurance policy as a triangle, says Amy Rose Herrick, a Chartered Financial Consultant and life insurance agent with offices in the U.S. Virgin Islands and Tecumseh, Kan. The three points of the triangle are as follows:

  • The policy owner -- the person who bought the policy and pays the premiums.
  • The insured -- the person whose life the policy covers.
  • The beneficiary -- the person designated to receive the death benefit when the insured dies.

"You always want two points of the triangle to be the same person, company or charity," Herrick says.

If there are three different people at the three points, then the death benefit could count as a taxable gift to the beneficiary.

How to avoid the tax trap

For example, a husband owns a policy on his wife's life and names their son the beneficiary. The wife dies, and the son receives the benefit amount. In the eyes of the IRS, since the husband was the owner of the policy, he has given a gift of the benefit to his son – making it a taxable gift amount.

The person who makes the gift -- the policy owner, not the beneficiary -- is the one who could be subject to gift taxes. Whether any tax is owed depends on how much is given away. Under federal tax law, you can give a certain amount every year and over a lifetime tax-free to someone. In 2016, the annual limit is $14,000 per recipient. The lifetime amount, known as the basic exclusion, is $5.45 million. Therefore, a married couple can give away $10.9 million over their lifetimes without paying gift taxes. (Money and property transferred to spouses is not taxed.)

To avoid the triangle, in the example above the wife could be both the policy owner and the insured party, then she could name the son the beneficiary. The benefit amount would not be considered a taxable gift. However, if the death benefit is included in her estate, and the value of the estate exceeds state or federal estate tax exemption amounts, then it could be taxed. In the event that the estate would be valued higher than the exemption amount, one solution may be having an irrevocable life insurance trust be the owner of the policy.

The unholy trinity trap is often overlooked, Herrick says. Even some life insurance salespeople are unaware of it, and it can occur with term life or permanent life insurance.

Life insurance should be part of a holistic financial plan. Work with a savvy adviser when you purchase coverage because estate planning and tax issues are complex, especially when you have a large estate.

More from Barbara Marquand here

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