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.

Key Takeaways

  • A beneficiary is an individual that receives a benefit, which is typically a monetary advantage.
  • The distributions typically come with tax consequences and sometimes various stipulations.
  • If the distribution is in the form of a retirement account, there are many factors to consider, such as time frame and distribution amounts, depending on the type of account.


Understanding a Beneficiary

Typically, any person or entity can be named a beneficiary of a trust, will, or a 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. 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.

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 nessicary plans.

A Beneficiary of Qualified 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 his or her 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

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.

In the event the beneficiary is either an estate or a trust, 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.

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, the gain of $50,000 is taxed as ordinary income to the beneficiary.