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 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:
- 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. (See more about who's who on a life insurance policy.)
"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.
Say, for instance, a husband owns a policy on his wife's life and names their son the beneficiary. The death benefit then is considered a taxable gift to the son.
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 2013, the annual limit is $14,000 per recipient. The lifetime amount is $5.25 million. A married couple can give away $10.5 million over their lifetimes without paying gift taxes. (Money and property transferred to spouses is not taxed.)
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.
For more, read these 10 ways to screw up when you name life insurance beneficiaries.
More from Barbara Marquand here