The Personal “Unholy Trinity”
When it comes to life insurance, it’s important to avoid making mistakes that could have significant financial consequences. One common mistake is known as the “unholy trinity,” which occurs when the owner, insured, and beneficiary are three different parties. In this scenario, if the insured passes away, the policy proceeds are considered a gift from the policyholder to the beneficiary. This can result in tax implications that could have been avoided with proper planning.
To illustrate this, let’s consider an example. Suppose a wife owns a life insurance policy on her husband’s life and names their two children as beneficiaries. On the surface, this may seem harmless, but it can lead to complications. In a federal court ruling from 1946, it was determined that if the “unholy trinity” exists at the time of the insured’s death, the policyholder has essentially gifted the proceeds to the beneficiaries. This means that upon the husband’s death, the wife is deemed to have made a gift of the earnings to her children. As a result, gift taxes may apply.
To avoid this mistake, it is best to ensure that the owner, insured, and beneficiary are the same person, or have the beneficiaries themselves be the policyholders.
What is the Solution?
To avoid the “unholy trinity” scenario, it’s best to have one person as the owner, insured, and beneficiary of the policy. This can easily be accomplished by naming the insured as the owner or having the beneficiaries themselves become policyholders. However, if the estate is subject to estate tax, it may be wise to have an entity such as an irrevocable life insurance (ILIT) trust own the policy.
In community property states, where each spouse is considered to own 50% of all community property, it’s important to pay premiums from the separate property of the owning spouse to avoid gift tax issues.
The “Unholy Trinity” in Business
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A similar mistake can occur when a company is the policy owner instead of an individual. This variation of the “unholy trinity” can have different tax consequences. If the insured, as a business owner, uses the business to own the policy and designates a third party such as a spouse, children, or other shareholder as the beneficiary, the proceeds may be subject to income tax instead of gift tax.
The specific nature of the taxes will depend on the relationship between the parties involved. Shareholders may face non-deductible dividends, while employees may face taxation on compensation. Seeking advice from expert advisors is crucial in this situation.
Lack of Appointment of a Successor Owner
It’s important to view an insurance policy as an asset and plan accordingly. Just like other assets, a life insurance policy should have a successor owner designated, especially if the owner and insured are two different individuals. If the owner passes away before the insured, the policy must pass to a successor owner to ensure smooth processing of proceeds to the beneficiary. Failure to designate a successor owner can lead to unnecessary costs, frozen assets, and delays.
To avoid this mistake, simply name at least one successor owner or have an entity such as a trust own the policy when the owner and insured are different people.
Naming the Estate as Beneficiary
Naming the estate as the beneficiary of a life insurance policy can be a costly mistake. If the insured’s estate is named as the beneficiary, the policy proceeds may be subject to estate taxes, creditor claims, and potential probate proceedings. This can result in unnecessary expenses and a delay in distributing the proceeds to the intended beneficiaries.
To prevent this error, it is generally advisable not to name the estate as the beneficiary. Instead, name specific primary and secondary (contingent) beneficiaries to ensure a smooth transfer of the policy benefits.
The Three-Year Inclusion Rule
If the insured owns or has “property incidents” on a life insurance policy at the time of their death, the entire death benefit may be included in their taxable estate for estate tax purposes. This means that the policy proceeds could be subject to estate taxes, which can be avoided with proper planning.
If an insured’s estate is subject to estate taxes, the ownership of the policy can create unnecessary tax liabilities. Transferring the policy to someone else or to a trust may seem like a quick fix, but there is a three-year inclusion rule to consider. This rule states that if the insured transfers the policy and dies within three years of the transfer, the proceeds will still be included in their estate and subject to estate taxes.
To navigate around this rule, it is important to consult with experts to find the best solution for transferring ownership of the policy without triggering unnecessary tax consequences.
Trustworthy Advice for Life Insurance
Purchasing and understanding life insurance can be complex, and mistakes can have significant financial implications. To avoid making costly errors, it’s important to seek advice from experienced professionals. At Kasmann Insurance, our life insurance experts are here to guide you through the intricacies of life insurance, answering all your questions and helping you make informed decisions.
Remember, learning from the mistakes of others is a wise approach to life, especially when it comes to something as important as life insurance.
[Note: The information provided in this article is for informational purposes only and should not be used as a means to avoid tax penalties. It is always recommended to consult with an independent tax advisor for personalized advice.]