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Beware the Bermuda...I mean Insurance...Triangle!


The Bermuda Triangle is a pretty scary place, or so I've heard.  Something equally scary involves the Insurance Triangle.  Are you scared yet?

The Insurance Triangle results from the fact there are 3 different "parties" to a life insurance policy.  Let's start out with who those parties are (one person can be more than one party).

  • Insured.  This is the party on which the policy is written.  In other words, when this person dies, the policy pays.
  • Owner.  Normally this is the party who pays the premiums and designates who will be paid when the insured dies
  • Beneficiary.  This is the party that gets paid when the insured dies

Life Insurance can be an effective estate planning tool and can even be an income tax sheltered or income tax free investment choice.  This is because Life Insurance proceeds pass to the beneficiary free from income tax.  But Life Insurance proceeds can be subject to estate taxation if the owner and the insured are the same person.

So, one way to avoid the estate tax problem is to make the owner and the beneficiary the same person.  Just in case you were wondering, anyone can own an insurance policy on anyone in which they have an insurable interest.  So, for example a divorced spouse who relies on alimony for living expenses could own a life insurance policy on the ex-spouse.  The bottom line is that if the owner of the policy and the beneficiary are the same person, the life insurance proceeds are free of estate and income tax.  But people try to get even more creative...

Enter the Insurance Triangle.  An Insurance Triangle exists when the three parties above are three different people (or entities).  When would this happen?  There are a lot of different scenarios.  I received a question the other day with this scenario.

  • Divorced Parent
  • Wanted to own policy on ex-spouse
  • Didn't want proceeds of the policy so wanted to name children (minors) as beneficiaries of the contract

Or here is another

  • Parent with two adult children
  • Wanted to name both children as beneficiaries on policy on parent's life and did not want proceeds in parent's estate
  • Younger child is special needs, so named older child as the policy owner (parent paid premiums)

In both cases above, when the insured dies, there will be a gift in the amount of the insurance proceeds, that could be taxable, to the one or more beneficiary (since they didn't own the policy).  In scenario 1 above, all the children will receive a gift (potentially subject to tax).  In scenario 2, the special needs child would receive a gift, again potentially subject to gift taxes.  Whether the proceeds will be subject to gift tax will depend on the size of the policy, previous gifts from the parent subject to taxation and the tax law in effect at the time of death (not that tax laws ever change).   Also, in scenario 2, the premiums could be subject to gift tax if they exceed the annual exclusion

You can avoid the triangle and accomplish the desires expressed in the two scenarios with effective estate planning and the use of insurance trusts.  But, as I always say, don't do estate planning without a net.  Get advice from a competent financial planner or estate planning attorney.

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Comment   |  5 years, 8 months ago from Alexandria, VA