Understanding the “Goodman Rule” of Life Insurance
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!