When Can a Life Insurance Payout Become Taxable?

By far, most life insurance payouts are not taxable, according to current IRS guidelines.  However, there are exceptions.  The purpose of this piece is to consider one of those exceptions which is referred to as the Goodman Triangle.

A Goodman Triangle occurs when a beneficiary(s) is not an owner or co-owner of a policy and a payout is made.  The beneficiaries of a policy payout will NOT be subject to any taxes in most cases if they were also owners or co-owners of the policy.  However, the portion of the payout which is going to be paid to a beneficiary(s) who is not an owner or co-owner will trigger a gift tax which the insured’s estate must pay and this gift tax will most likely be paid from the beneficiary portion of the payout.

A Goodman Triangle can easily be avoided, just as many taxes can be legally avoided, with proper planning.  One method of preventing a Goodman Triangle from occurring is to list all beneficiaries as owners or co-owners. This works well when there are only a few beneficiaries but can become cumbersome when a plethora of beneficiaries are involved.

As the gift tax is only assessed on gifts over the value of $15,000 per person annually, with a life time exclusion of $11.7million, the Goodman Triangle only becomes problematic when a payout exceeds these thresholds.

Obviously, if a spouse owns a policy on their partner and the partner dies, there is no taxation on the payout. However, if the children of this partnership receive payouts from this policy, then those payouts are considered a gift from the surviving spouse because the children were not owners but only beneficiaries of the policy.  This gift, therefore, is subject to IRS guidelines as mentioned above.

The same is true for a child who owns a policy on a parent and the other beneficiaries including this policyowners siblings.  The owner/child’s proceeds of the payout will not be subject to the gift tax but the siblings proceeds will be subject to the gift tax regulations.  In this case the owner/child will be the one who is responsible for complying with the gift tax guidelines.

The gift tax is a tax on property transferred to one individual to another while receiving nothing, or less than full value, in return.  And even though the life-time gift allowance is currently at $11.7 million, the congress and administration are working hard to reduce this gift allowance.

Another way to prevent a Goodman Triangle from occurring is to name a trust as the owner/beneficiary of a life insurance policy.  Using a trust in this manner allows the trustee of the trust to distribute the funds received in a life insurance payout according to the wishes of the settlor or trustor without the gift tax being involved.

On certain occasions an irrevocable trust can be utilized to protect the payout of a life insurance policy from becoming taxable.  An irrevocable life insurance trust (ILIT) is often used in estate planning to replace the value of specific assets which the heirs would normally inherit. This can avoid some or all of the estate tax which would have been due upon the death of the insured had those assets not be gifted, sold or donated and their value replaced with the life insurance.

Charitable remainder trusts are also valuable tools to use when a large estate needs to be broken up prior to the death of an insured to avoid unnecessary taxation on the estate or even to skip a generation.

The take home message about “When can a life a life insurance payout become taxable” is this.  A life insurance policy payout never has to become taxable if proper planning has been done and the required steps have been taken within the set time limits.  That planning and programming must come prior to the death of the insured, many time at least three years before that death, so the sooner such plans are made and implemented the better.

Life insurance has been a valuable financial tool for centuries. Expending the effort and the time commitment to understand and fully benefit from all the advantages of owning life insurance is more than worth it for those who implement the knowledge into their lives.  Our purpose here at McFie Insuranceis to provide the knowledge and resources you need to live your life fully while leaving an incredible legacy for those you love and admire once you are gone.  It has been said, “A good person leaves a legacy for their children’s children.“ We couldn’t agree more.

Dr. Tomas P. McFie

Most Americans depend on Social Security for retirement income. Even when people think they’re saving money, taxes, fees, investment losses and market volatility take most of their money away. Tom McFie is the founder of McFie Insurance which helps people keep more of the money they make, so they can have financial peace of mind. His latest book, A Biblical Guide to Personal Finance, can be purchased here.