There’s no argument that life insurance is a useful way to provide for your heirs and loves ones when you die.
If you’re looking into buying life insurance, one of the first things an agent will tell you is that life insurance proceeds are paid out tax-free to beneficiaries. However, while life insurance proceeds are tax-free in most situations, it’s important to realise that there instances where life insurance may have adverse income, estate and even gift tax consequences. Here are some life insurance tax traps you may want to avoid.
1. The Unholy Trinity
Also known as the “Goodman Triangle.” This tax trap happens when three different people play the roles of the policy owner, insured and beneficiary. Think of a life insurance as a triangle where the three points are;
- The policy owner — the person who purchased the policy and pays the premium
- The insured — the person whose life the policy covers
- The beneficiary — the person who’ll receive the death benefit when the insured dies
You’d always want two points of the triangle to be the same person, company or charity because if there are three different people to represent the three points, then the death benefit may count as a taxable gift to the beneficiary.
2. Key Employee Insurance On Not-So-Key Employees
Let’s say you own a business which purchases life insurance policies on a non-owner “key” employee and names itself as beneficiary. The employee retires, yet your business retains the policy. When the employee dies, the life insurance proceeds will be income taxable to the extent the proceeds are greater than the premiums paid for the policy.
That is if the said employee was not a part of the business for over a year and was not a director or a highly compensated individual. What you should do is to give proper notice and consent to the employee and allow the employee to take over the life insurance policy at retirement. You can also pay the proceeds to the insured’s family after death where they get an exemption from paying income tax.
3. Living Trust As Beneficiary
Since you don’t want your life insurance to proceed to be subject to estate tax, you may name your revocable living insurance trust as the beneficiary of your insurance policy. However, you may have overlooked the fact that any incident of ownership will cause the life insurance policy to be included in the taxable estate and since you have full control over your revocable trust, you won’t be able to avoid estate tax. What you should do is to draft an irrevocable life insurance trust and name it as the owner and beneficiary of your policy.
Since the trust is irrevocable, you’ll have no incidents of ownership and the proceed with be excluded from your estate.
4. Children As Beneficiaries
In order to avoid estate tax, you name your adult child as the owner of your insurance policy, and name your other children as beneficiaries. However, this situation is a violation of the Goodman Rule where the child who owns your policy would be deemed to have made a taxable gift to the other children. So, whether it be your spouse, adult children or a life insurance trust, make sure the owner and the beneficiary of your life insurance policies are exactly the same.
5. New Trust, Old Policy
Usually, there won’t be any issue if your current life insurance policy lists you as the owner and you want it to be owned by your new irrevocable life insurance trust. Just be wary of the three-year look-back rule, which states that any life insurance policy you owned over the last three years before death will be included in your taxable estate. So, if it’s a term policy, consider re-applying for coverage and naming the trust as the owner of the new policy. If a new policy isn’t cost effective, then you may want to outlive the three-year time period.