An incidental beneficiary is someone who benefits only because someone else benefits. While the term can be used generically in a wide range of circumstances, the insurance and finance industries usually use it in relation to the disposition of a will, trust or other similar agreement. Sometimes called an indirect beneficiary, an incidental beneficiary contrasts with a direct beneficiary, which is the person or entity specifically named in the agreement.
Generally speaking, an incidental beneficiary is considered incidental because the source of the benefit did not make provisions to directly benefit him. For example, the creator of a will or trust might direct that his assets be divided between his adult children. In this case, each of the children is a direct beneficiary. Most likely, however, the spouses and descendants of those children will benefit from the inheritance as well, making each of them an incidental beneficiary.
Traditional mortgage life insurance can be an excellent example of the difference between direct and indirect beneficiaries. This insurance is designed to pay off the mortgage balance owed on a home in the event of the policyholder's death. In this situation, the direct beneficiary is the mortgage company because it is named in the policy and the funds are paid directly to it. The incidental beneficiary or beneficiaries would be those who inherit the house, typically the policyholder's family.
In trust situations, the nature of the beneficiary affects taxation as well. A direct beneficiary may be subject to inheritance or income taxes, whereas an indirect beneficiary usually is not. This is also true in most areas where life insurance is taxable.
Tax considerations can play a significant role in an individual's beneficiary decisions. For example, in some areas, the rate of taxation differs based on whether inherited funds are directly distributed to beneficiaries in a lump sum or fed into a trust set up to distribute the funds to beneficiaries over time. In addition, taxes for individual beneficiaries might differ from the taxes paid by corporate beneficiaries.
For this reason, a person might name a mortgage company or other creditor the primary beneficiary rather than designating his spouse the beneficiary. This way, the spouse benefits from having the debt paid off without dealing with tax implications. This strategy is generally most effective for policies set up to address this specific situation or for short-term policies as opposed to whole life or universal policies.
