Beneficiary

What Is a Beneficiary?

A beneficiary is any person who gains an advantage and/or profits from something. In the financial world, a beneficiary typically refers to someone eligible to receive distributions from a trust, will, or life insurance policy. Beneficiaries are either named specifically in these documents or have met the stipulations that make them eligible for whatever distribution is specified.

Understanding a Beneficiary

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 put various stipulations on the disbursement of funds, such as the beneficiary attaining a certain age or being married. Also, there can 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.

One of the most important things to determine after retiring, if not before, is that all assets will end up in the right hands. Failing to name beneficiaries could have disastrous effects on a family’s financial health should you or your spouse die without making the necessary plans.

Warning

When you pass away without a will in place, you’re deemed intestate and your assets are distributed not to any chosen beneficiaries but according to state inheritance laws.

A Beneficiary of Qualified Accounts

Qualified retirement plans, like a 401(k) or an individual retirement account, (IRA), give the account holder the ability 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, then 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 for Inherited Retirement Accounts

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. Only the lump-sum and five-year rule options are available going forward. The SECURE Act stipulates that most non-spousal beneficiaries of an IRA must take distributions equal to the entire account balance within 10 years.

If the beneficiary is either an estate or a trust, then the distribution rules are more limited. Any proceeds left to the estate also make it subject to probate.

A Beneficiary of Life Insurance

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.

Life insurance beneficiaries can be individuals, such as a spouse or adult child, or entities, such as a trust. For example, if you have minor children, then you may choose to establish a trust and name it as the beneficiary of your life insurance policy. If you were to pass away, then the policy’s death benefit would be paid to the trust. The trustee would then be charged with managing those assets according to the terms of the trust on behalf of its beneficiaries (e.g., your children).

Minor children can’t directly receive the proceeds of a life insurance policy, but you could name a trust or your children’s legal guardian as a beneficiary.

Revocable Beneficiary vs. Irrevocable Beneficiary

Life insurance beneficiaries can be revocable or irrevocable. Revocable beneficiaries can be changed if necessary at any time during the policy owner’s lifetime. This is similar to a revocable living trust, which can also be changed as long as the trust grantor is still living.

An irrevocable beneficiary is permanent. If there are multiple beneficiaries named to a life insurance policy (e.g., a primary beneficiary and several contingent beneficiaries), then they would all need to consent to any changes involving an irrevocable beneficiary.

Who Can Change the Beneficiary on a Life Insurance Policy?

In the case of a life insurance policy that has one or more revocable beneficiaries, the owner of the policy can change the beneficiary designations at any time. This is something that may be necessary if a beneficiary passes away or if the primary beneficiary is a spouse and the marriage ends in divorce.

If irrevocable beneficiaries are named to a life insurance policy, then the policy owner would need the consent of the beneficiary and any contingent beneficiaries to make a change. For that reason, it’s important to think carefully when choosing policy beneficiaries.

A Beneficiary of a Nonqualified Annuity

Nonqualified 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, then some or all of the gain of $50,000 may be taxed as ordinary income to the beneficiary.

Important

If you have been designated as the beneficiary of a nonqualified annuity, consider talking to an accountant or other tax professional about the potential tax implications.