Important Things to Know About Being a Beneficiary

Marissa Scott
September 16, 2021

The basic definition of a beneficiary is any person who receives financial distributions from an account at the request of the owner of that account. It’s common to name a beneficiary for things like life insurance policies, trusts, and wills. You may also be able to name beneficiaries on other accounts such as savings accounts or CD accounts. If you are the beneficiary of another person’s account, it typically means that you will receive money should something happen to the policy holder. 

While it’s very common to name a beneficiary on an account, many people do not fully understand what it means to be a beneficiary, or how receiving a payout will impact them. Here are some important things to know about being a beneficiary:

Who can be a Beneficiary?

Exactly who can be named as a beneficiary will depend on the financial institution where the account is located. In some cases, the account owner can name anyone as a beneficiary, including minor children or trusts benefitting charitable organizations. Other financial institutions may have stricter beneficiary requirements. If minors are allowed as beneficiaries, it’s important to note that the law does not allow anyone under 18 to receive payout distributions directly. What happens to a minor’s beneficiary payout will depend on where they live and how large the payout is.

In some cases, account holders can name more than one beneficiary on an account. If this is allowed by the financial institution, a specific percentage of the total account value can be designated to go to each beneficiary. This is often the case when people have multiple children that they would like to split the funds amongst. Beneficiaries can typically be added and removed at any time by the account holder. In some cases, like with a trust account, it’s also possible to dictate that a beneficiary reach a certain milestone, such as being a certain age or graduating from college, before they can receive a beneficiary distribution. 

Receiving the Distribution 

The beneficiary of a life insurance policy will typically receive a death benefit payout in the form of tax-free distributions that they do not need to claim as gross income. However, if the distribution is not paid out immediately and instead is held in an interest-bearing account after the benefactor’s death, the Internal Revenue Service (IRS) will tax any interest earned on the death benefit. Usually, a life insurance beneficiary either receives their payout as a lump sum, or according to a payout table which is typically established when the original policy holder opens the account. 

In the case of a retirement account such as a 401(k) or Individual Retirement Account (IRA), the beneficiary typically has the option of rolling the payout directly into their own retirement account, or requesting a direct payout distribution. Although the beneficiary of a retirement account is usually a spouse, the IRS recognizes that this isn’t always the case. There are different distribution options available for non-spousal beneficiaries depending on when the account holder passed away. Another potential option for beneficiaries of retirement accounts is to keep the funds in the original account for up to 10 years. The beneficiary must ensure that all distribution requests are made within the allowed time-frame.

Another type of inheritance a beneficiary may receive is an investment, such as an annuity. With an investment account, the IRS taxes any proceeds paid to the beneficiary that exceed the original investment amount. For example, if the value of the original annuity was $50,000 at the time of purchase and $75,000 when the owner died, the beneficiary would be liable for federal income tax on $25,000.

In the case of a savings account, the bank will typically release the account balance to the beneficiary after the account owner has died. A beneficiary payout from a savings account is considered a cash inheritance, and thus is not taxable. A CD account can be a bit more complicated, depending on how the beneficiary handles the inheritance. If the CD itself is transferred to the beneficiary, the current value of the CD will not be taxable. However, any interest earned on the CD after the original account holder’s death would count as income for the beneficiary and would be subject to taxes. Another option is for the beneficiary to close the CD and withdraw the funds when the original account holder dies. It’s important though that the beneficiary be aware of potential early withdrawal penalties. Many financial institutions will waive such fees in the event of an account holder’s death, but they aren’t required to.

Special Types of Tax Situations

In addition to the circumstances listed above, where a beneficiary may have to pay income tax on interest earned on an inheritance after the account holder dies, it’s worth noting that there are six states that also require beneficiaries to pay a separate “inheritance tax”. The inheritance tax applies to beneficiaries residing in Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. While each of these states have their own formula for determining the amount of inheritance tax owed, a beneficiary will typically pay less in inheritance tax the more closely related they are to the deceased, with some close relatives not having to pay any inheritance tax at all.

As for estate taxes, these do not affect a beneficiary unless they inherit an estate worth more than $11.7 million dollars in 2021. This threshold is adjusted each year to account for inflation, and has increased slightly from $11.58 million in 2020. If estate tax does apply to a beneficiary, it’s worth noting that the IRS only taxes the value of anything over the threshold, while exempting any amount below it. It’s also important to keep in mind that if a beneficiary inherits a property that they later sell, they will have to pay capital gains taxes on any profit made from the sale. They would owe no additional taxes if they sold the property at a loss.

As with any major financial change or decision, it’s a good idea to consult a financial professional or a tax advisor to ensure you fully understand any tax implication of an inheritance. Being a beneficiary could bring some unexpected funds your way, but it’s important to understand exactly how that money will affect you.

For more information on naming a beneficiary to your Bank5 Connect account, contact us today.

You May Also Like: