The word beneficiary is often tossed around in casual conversation, but, in some cases, it has a specific legal meaning. Many workplace benefits, insurance policies, bank accounts, and other assets will ask you to designate a beneficiary.
What does that mean? Why does it matter? Is there a right way and a wrong way to designate a beneficiary? What do you need to know if you’re someone else’s designated beneficiary?
Here are the answers to those questions.
What is a beneficiary?
Merriam-Webster defines a beneficiary as “a person or thing that receives help or an advantage from something: one that benefits from something.”
In the world of finance, a beneficiary is a person, organization, or other entity designated to receive the benefits of assets owned by someone else. This often comes as part of an inheritance.
In estate planning, for example, assets can be left to an individual, a trust, or a charitable organization. In some cases, there can be significant tax benefits for doing so.
Although beneficiaries are often thought of as part of the estate planning process, many beneficiaries are named in documents outside of a will.
How to name beneficiaries
Anyone who buys life insurance or opens a bank or retirement account will be asked to name a beneficiary. Usually, account holders will have the option of designating more than one beneficiary.
When listing more than one beneficiary, account holders can divide up the assets by percentage (“give 50% to each beneficiary”) or by dollar amount (“give the first $10k to Person X and the remainder to Person Y”).
Beneficiaries can generally be changed anytime, though some life insurance policies may have irrevocable beneficiaries and cannot be easily removed.
When a beneficiary is named as part of an account, that designation will generally override any estate planning.
For example, following a divorce you may update your will to make sure your money goes to your kids. However, if you don't update the beneficiary designations to name your kids as well, your life insurance, IRA, and other assets will still go to your ex-spouse since beneficiary elections trump your will.
In estate planning, beneficiaries can also be contingent. For example, money can be left to a relative, but if that relative has died or can’t be found that money can be designated for someone else or divided among other beneficiaries.
Often, people leave money to a relative and designate that if the relative predeceases them, those assets should go to the relative’s children.
Some beneficiaries, such as minors, may not be eligible to directly receive assets. In those cases, someone will be named to manage those assets until the minor becomes of age or some other milestone is reached.
Generally, a court-appointed person (known as a conservator) must claim and manage the money until the minor turns 18. However, in many cases, having an attorney create a trust to manage the minor’s care and leaving assets to that trust might be an easier solution.
Common mistakes to avoid
Being named a beneficiary can have unintended consequences. Therefore, reviewing beneficiaries with an accountant, attorney, financial planner, or other professional is typically a prudent move.
Here are a few examples:
- A disabled person receiving government benefits may no longer be eligible if they inherit money.
- Individuals with financial issues or creditor problems may lose those assets to creditors.
- College students with need-based scholarships may lose those scholarships.
Beneficiaries should be reviewed and updated regularly to reflect any changes. Also, be aware that even a minor typo in someone’s name or a name change due to marriage or divorce can significantly delay any inheritance.
If you don’t name a beneficiary for a specific account, the state will distribute those assets upon death.
This can be lengthy and time-consuming, and the process can take months or even years. Depending upon state laws, those assets could very well be distributed to people the decedent might not have chosen.
What to do if you’re a beneficiary
The first step is to consult a tax professional if you're left money or other assets. Some assets will pass from the originator to the beneficiary with minimal or no taxes, while other assets may be subject to significant tax bills.
For example, parents may have bought a home many years ago for $100,000 and left it to their children in their will.
When they die, the home is worth $500,000. For tax purposes, the home will be valued at $500,000 (called the basis) when the children inherit it. The basis will be used to calculate any capital gains taxes when the children sell the house. The same process occurs for most investment accounts.
Other assets may be treated differently by federal and state tax authorities. Again, it’s generally a good idea to consult a tax professional.
Designating beneficiaries can be complicated, especially as part of the estate planning process. A CFP® Professional at Facet can help you make those choices and avoid pitfalls.
