One of the great advantages of life insurance is it provides a tax free death benefit most of the time. Typically, your beneficiaries will receive the proceeds from your policy and not have to worry about paying any taxes on the money. That is unless your life insurance is not set up properly. What I mean is you might have inadvertently set up a tax trap within your policy.
There are three different individuals involved in a life insurance policy; the policy owner, the insured and the beneficiary. The policy owner is, as the name implies, the individual who owns the policy. The insured is the individual whose life the policy covers. Lastly is the beneficiary, the person designated to receive the death benefit when the insured dies.
As long as two of the three individuals involved are the same, the death benefit should be a non-taxable event. Unfortunately, if all three individuals involved are different, then the death benefit could count as a taxable gift to the beneficiary. For example, if a wife owns a policy on her husband’s life (he is the insured) and their daughter is the beneficiary then the death benefit is considered a taxable gift to the daughter.
In the previous scenario, the individual who makes the gift, the wife as the policy owner, not the beneficiary, is the individual who is responsible for the gift tax. Whether or not any gift taxes must be paid is dependent upon how much the death benefit is when given to the beneficiary. The maximum gift for 2014 is $14,000 but this might be increased for future years.
This situation was tested in the court system and nicknamed “the Goodman Triangle” after the 1946 case, Goodman v. Commissioner of the Internal Revenue Service. A “Goodman Triangle” occurs as described above when three different individuals are named as the policy owner, insured, and beneficiary.
Life insurance can be a very important part of a financial plan as long as it is structured properly. Therefore, when initially applying for a life insurance policy be very conscientious about avoiding a potential tax trap by making sure at least two of the three individuals involved are the same. Additionally, it is always advisable to work with a knowledgeable insurance agent to ensure your policy meets all your needs as well as remains tax-free.
Submitted by Kathy Shrader, Postema Accounting Solutions
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