Beneficiary Clause

What Is a Beneficiary Clause?

A beneficiary clause is a provision in a life insurance policy or other investment vehicle such as an annuity or individual retirement account (e.g., an IRA), that permits the policy owner to name individuals as primary and secondary beneficiaries.

Understanding Beneficiary Clauses

A beneficiary clause defines the individuals who will benefit from the funds or other benefits from the policyholder or benefactor. The policy owner may change the named beneficiaries at any time by following the specifications defined in the policy. The term beneficiary refers to the specification of the recipient of funds or other benefits as specified in a policy or trust.

Typically, any person or entity can be named a beneficiary of a trust, will, or life insurance policy. The individual distributing the funds, or the benefactor, can place stipulations on the disbursement of funds, such as the beneficiary attaining a certain age or being married. There can also be tax consequences to the beneficiary. For example, while the principal of most life insurance policies is not taxed, the accrued interest might be taxed.

Beneficiaries of Qualified Retirement Accounts

Qualified retirement plans, like a 401(k) or IRA, give the ability of the account holder to designate a beneficiary. Upon the qualified plan holder’s passing, a spousal beneficiary may be able to roll the proceeds into their own IRA. If the beneficiary is not the spouse, there are three different options for distribution.

The first is to take a lump-sum distribution, which makes the entire amount taxable at the beneficiary’s ordinary income level. The second is to establish an inherited IRA and withdraw an annual amount based on the life expectancy of the beneficiary, also known as a "stretch IRA." The third option is to withdraw the funds at any time within five years of the original account owner’s date of death.

The stretch option is no longer available for an inheritance received in 2020 due to the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, and thus only the lump-sum and five-year rule options are available going forward. The SECURE Act stipulates that a beneficiary of a retirement account must take all distributions within 10 years.

Beneficiaries of Life Insurance Policies

Life insurance policies require named beneficiaries to be designated. These can be designated as primary, secondary, or tertiary in the event that the primary and/or secondary named beneficiaries have passed away before the death of the insured. The beneficiary may be an individual, an organization (e.g., a charity), or a trust.

Life insurance proceeds are considered tax-free to the beneficiary and are not reported as gross income. However, any interest received or accrued is considered taxable and is reported as any other interest received.

Beneficiaries of Non-qualified Annuities

Non-qualified annuities are considered tax-deferred investment vehicles that allow the owners to designate a beneficiary. Upon the death of the owner, the beneficiary may be liable for any taxes on the death benefit. Unlike life insurance, annuity death benefits are taxed as ordinary income on any gains above the original investment amount.

For example, if the original account owner purchased an annuity for $100,000 and then passed away when the value was worth $150,000, the gain of $50,000 is taxed as ordinary income to the beneficiary.