Goodman Triangle - The Unholy Trinity of Life Insurance

Goodman Triangle – The Unholy Trinity of Life Insurance

As for dramatic names, the Goodman Triangle wins the competition with the moniker “Unholy Trinity of Life Insurance”. Maybe I watched too many horror movies as a kid (don’t tell my mom) but when I hear that I envision something much more sinister than a tax scenario involving life insurance.

While an exorcism won’t be required to fix or avoid this situation it is good to be aware of it. If you find yourself in a Goodman Triangle your head may still spin while you vomit profusely.

What Does this Have to do with Retirement?

Retirement income planning is all about balancing income security and lifestyle. In other words, figuring out how much income you can take without depleting your account. This basic trade-off is the premise of the 4% rule. Since many people will want to tilt this balance to the safe side, leaving an inheritance is likely.

Since it is generally not taxable, life insurance is a common tool for passing an inheritance to your heirs.

What is a Goodman Triangle?

To understand the Goodman Triangle you need to think about the people involved in a life insurance policy. There are three relevant parties to a life insurance contract:

  1. The owner
  2. The insured
  3. The beneficiary
Owner: The policy owner has control of the policy. They can name beneficiaries, terminate or alter the policy, and have the responsibility of ensuring the premiums are paid
Insured:This is the person whose life is insured by the policy.
Beneficiary:The beneficiary receives the death benefit when the insured passes. A policy can have multiple beneficiaries.

In most cases, life insurance proceeds from a death benefit aren’t taxable. For instance, if you own a policy on your spouse and are the beneficiary. When your spouse dies you won’t owe taxes on the amount you receive.

A Goodman Triangle arises when there is a non-owner beneficiary. Here, if you own a policy on your spouse and name your child as the beneficiary. When your spouse dies, the amount your child receives is taxable.

Why is it Taxable?

Since the child didn’t own the policy, the amount of the death benefit they receive is considered a gift. Gift tax rules will dictate how it is taxed.

An important consideration here is to understand when the gift occurs. The taxable gift occurs once the gift has been completed.

Before the death of the insured, the policy owner has the ability to change or even cancel the policy. That means that the gift has not been completed before the death of the insured, because the owner could:

  1. Change the amount of the eventual gift by increasing or decreasing the death benefit.
  2. Alter the policy by adding or removing beneficiaries. If the number of beneficiaries changes then the way the death benefit is shared among them will change.
  3. Cancel the policy and therefore no gift would ever occur.

It makes sense then that the gift becomes completed once the insured dies because all of those options are off the table. The death of the insured is the triggering event that completes the gift. At that point, the beneficiary will receive the proceeds.

How Can I Avoid the Unholy Trinity of Life Insurance?

There are several things you can do to avoid a Goodman Triangle. Each strategy has pros and cons that you should carefully consider before you decide which one you will use.

Make the Beneficiary and the Owner the Same Person

If you, as the owner, take a policy out on your spouse, simply name yourself as the beneficiary. It’s no longer a taxable gift, but the obvious issue here is that the intended beneficiary no longer receives the death benefit.

However, if you make the child the owner and leave them as the beneficiary then any premiums you pay are considered completed gifts. If the premiums are above the annual gift-tax exclusion amount then they will be taxable.

Lastly, don’t name your spouse as the owner of the policy on which they are also the insured. This will make their estate the recipient of the death benefit, possibly creating estate tax and probate issues.

You could use an Irrevocable Life Insurance Trust

An irrevocable life insurance trust or ILIT, is created for the express purpose of holding life insurance so that the death benefit avoids estate tax. You would name the trust as both the owner and beneficiary of the policy. The trustee of the ILIT then handles the proceeds in accordance with the trust document for the benefit of the trust beneficiaries who would presumable be the children you would have otherwise names as the beneficiaries on the policy.

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