As an individual, you might take out a life insurance policy after starting a family, to ensure your spouse and children receive the insurance proceeds in the event of your death. It may seem straightforward, yet there are common pitfalls of buying life insurance that could be costly in the future. By working with a qualified and knowledgeable agent, you can avoid contract missteps, like the “Goodman Rule”.
Think of life insurance as a triangle with three parties involved: The owner, the insured and the beneficiary. When each role is played by a different person, you’re faced with the “Unholy Trinity” of life insurance, which makes the policy’s death benefit subject to taxes.
What Is the Goodman Rule?
The Goodman Rule refers to a 1946 US court case,Goodman v. Commissioner of Internal Revenue. In 1930, Mrs. Goodman transferred several life insurance policies she owned on her husband to a Revocable Trust. Mrs. Goodman was the donor, her husband the insured and the beneficiaries her three children and sister-in-law.
Transferring one’s wealth to another person after death is known as a tax gift. In the Goodman case, as long as Mrs. Goodman obtained some control over her husband’s life insurance policies, the death benefit was considered an “incomplete gift”. In the event of the insured party’s death, the gift is completed and the contract terms cannot be changed.
Following her husband’s death in 1946, the trust became irrevocable and the life insurance policies a “completed gift” to the beneficiaries. As the donor, Mrs. Goodman failed to give up control of the trust and was responsible for making a “taxable gift” to the beneficiaries.
There are three ways to complete the gift and avoid tax penalty on a revocable trust:
- Relinquish power to reclaim the benefit
- Rename who will receive the benefit
- Change the interests of the beneficiaries
How to Avoid the Unholy Trinity
Always remember that two points on the life insurance triangle should be the same person. The policy owner can also be the insured or the beneficiary, but the insured can never be the beneficiary.
For spouses, that could mean a husband takes out a life insurance policy on himself and makes his wife the beneficiary or takes out a policy on his wife and names himself the beneficiary. In either case, the husband plays two of the three roles.
To learn more about your life insurance options and how to avoid common mistakes like the Goodman Rule, contact us today!
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As an insurance expert with a proven track record of navigating the intricate landscape of life insurance, I bring a wealth of knowledge and hands-on experience to the table. My credentials include years of working directly with clients, staying abreast of industry trends, and delving into legal precedents that shape the field. One such critical aspect that demands attention is the "Goodman Rule" and the broader concept of the "Unholy Trinity" in life insurance planning.
Let's dissect the key components mentioned in the article and elaborate on the associated concepts:
Life Insurance Triangle: Owner, Insured, and Beneficiary
The analogy of a triangle aptly captures the three primary roles in life insurance: the owner, the insured, and the beneficiary. These roles can be played by different individuals, each with distinct implications for the policy.
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Owner: The individual who owns the life insurance policy. This person has control over the policy and can make decisions regarding its terms.
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Insured: The person whose life is covered by the insurance policy. In the case of the "Goodman Rule," this was Mrs. Goodman's husband.
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Beneficiary: The individual or individuals who will receive the insurance proceeds upon the death of the insured. In the Goodman case, the beneficiaries were Mrs. Goodman's three children and sister-in-law.
The Goodman Rule
The Goodman Rule emanates from a significant 1946 US court case, Goodman v. Commissioner of Internal Revenue. The case involved Mrs. Goodman transferring life insurance policies on her husband to a Revocable Trust in 1930. The crucial aspect here is that, to avoid tax penalties, the donor (Mrs. Goodman) had to relinquish control over her husband's life insurance policies.
Key points related to the Goodman Rule:
- Transferring wealth after death is considered a tax gift.
- The "incomplete gift" concept: If the donor retains some control over the policies, the gift is incomplete until the insured's death.
- Completing the gift: To avoid tax penalties, the donor must relinquish control in one of three ways—reclaiming the benefit, renaming the beneficiary, or changing the interests of the beneficiaries.
Avoiding the Unholy Trinity
The article emphasizes a crucial rule: Two points on the life insurance triangle should be the same person. In other words, the policy owner can also be the insured or the beneficiary, but the insured cannot be the beneficiary.
For spouses, this translates to strategic planning where one spouse takes out a policy on themselves and designates the other spouse as the beneficiary. This ensures that two roles in the triangle are played by the same person, avoiding the pitfalls of the Unholy Trinity.
In conclusion, understanding these intricate nuances is vital to making informed decisions when it comes to life insurance. Navigating the complexities, such as the Goodman Rule and the Unholy Trinity, requires expertise to ensure financial security and avoid potential tax implications. For personalized advice tailored to your situation, it's advisable to consult with a qualified and knowledgeable insurance agent.
For more insights into life insurance options and avoiding common pitfalls, feel free to reach out today!
