Inheriting an annuity: rules, taxes, and options
Beneficiary options vary by spouse vs. non-spouse, qualified vs. non-qualified, and the 5-year and 10-year payout rules.
Inheriting an annuity comes with choices that have very different tax outcomes — and a tight clock. If you are the surviving spouse, you can almost always keep the contract going tax-deferred; if you are a non-spouse, your job is to spread the taxable gain over as many years as the rules allow instead of taking it all at once. This guide covers how the rules differ, what the tax actually looks like in dollars, the payout options compared side by side, the deadlines that can trap you, and the steps to take in the first few weeks.
How an inherited annuity works
An annuity is a contract with an insurance company, and when the owner dies it pays out to whoever is named as beneficiary on the contract — not according to a will. That is the first thing to confirm: the beneficiary designation controls, so check the paperwork before assuming anything.
Two questions then determine every rule that follows. First, is the annuity qualified (held inside an IRA or other pre-tax retirement account) or non-qualified (bought with after-tax money)? Second, are you the deceased's spouse or a non-spouse (a child, sibling, friend, or trust)? Those two axes decide your payout options and your tax timeline.
The one thing that does not change: an inherited annuity gets no step-up in basis. Unlike inherited stock or real estate, the gain inside the annuity stays fully taxable to you as the beneficiary.
Spouse vs. non-spouse
- Spouse: usually can do a "spousal continuation" — step into the contract and keep it tax-deferred as if it were theirs. The most flexible, tax-friendly option.
- Non-spouse: cannot continue it the same way. You choose among a lump sum, a multi-year spread, or (sometimes) annuitizing — each with different tax timing.
This single distinction is the most valuable thing to understand. A spouse who elects continuation may owe no tax at all in the year of death and can let the money keep compounding. A non-spouse, by contrast, has started a countdown the moment the owner died, and the only real lever is how the taxable gain gets spread across the years that remain.
The tax reality
Annuities get no step-up in basis. Beneficiaries owe ordinary income tax on the gain (growth above the original cost basis) in a non-qualified annuity, and on every dollar of an inherited IRA annuity. A lump sum means all that gain is taxed at once (often pushing you into a higher bracket); spreading withdrawals over allowed years can substantially lower the total tax. The IRS governs the payout/withdrawal timelines for inherited annuities.
Non-qualified annuities follow a last-in, first-out (LIFO) rule: every dollar of withdrawal is treated as taxable gain first, and you only reach your tax-free basis after the entire gain is exhausted. So with a contract that has grown, early withdrawals are fully taxable. There is some good news on penalties — distributions a beneficiary receives because of the owner's death are exempt from the 10% early-withdrawal penalty, even if you are under 59½.
The numbers: lump sum vs. spreading
Round figures make the stakes obvious. Say you inherit a non-qualified annuity worth $300,000, of which $120,000 is taxable gain (the original owner contributed $180,000 of after-tax basis). You are a non-spouse beneficiary.
- Lump sum: all $120,000 of gain lands on this year's return. Stacked on top of, say, $90,000 of wages, a single filer's gain is taxed at 22% and mostly 24% under 2026 brackets — call it roughly $28,200 in federal tax, and it may trigger an extra year of higher Medicare premiums on top.
- 5-year spread: take the gain in slices of about $24,000 a year across five years and every dollar of it stays in the 22% bracket — roughly $26,400 total, a savings of about $1,800, plus you avoid the IRMAA spike. (Two $60,000 years saves only about $600, because much of the gain still lands at 24%.)
The exact savings depend entirely on your other income each year, so the lesson is the method, not the precise dollar: every year you can add to the payout window is a year of gain you can tax at a lower rate. Run your own numbers before you commit.
Your options, compared
| Option | Tax effect |
|---|---|
| Lump sum | Entire gain taxed now — usually worst |
| Spread over allowed period | Tax spread across years — often best |
| Annuitize (if offered) | Exclusion ratio spreads tax over payments |
| Spousal continuation | Defer — most flexible (spouse only) |
The five distribution options for a non-qualified annuity
| Option | Tax timing | Best for |
|---|---|---|
| Lump sum | All gain taxed in year received | Small contracts; immediate need |
| 5-year rule | Withdrawals spread over 5 years | Moderate balance; want bracket smoothing |
| Life-expectancy payout (non-qualified "stretch") | Payments spread over your life expectancy; taxed gains-first — fully taxable until the gain is used up, then a tax-free return of basis | Non-spouse heirs who want the longest deferral — must start within one year of the owner's death, and not every insurer offers it |
| Spousal continuation | Treat as if your own annuity | Surviving spouses only — usually optimal |
| Annuitize (life option) | Exclusion ratio applies per payment | Larger balances; longevity hedge — a non-spouse must start payments within one year of the owner's death |
Annuitizing deserves a closer look because it is the most misunderstood choice. When you annuitize, the insurer applies an exclusion ratio — each monthly payment is treated as part tax-free return of basis and part taxable gain, spreading the tax bill across the whole stream rather than front-loading it. It is the natural fit for a beneficiary who wants predictable lifetime income and is comfortable giving up access to the lump sum. A non-spouse must start the payments within one year of the owner's death; after that, only a lump sum or the 5-year rule remains.
Spousal continuation: the option most surviving spouses miss
If you're the surviving spouse on a non-qualified annuity, "spousal continuation" lets you assume the contract as if you'd always owned it. The annuity continues to grow tax-deferred, the surrender schedule continues, and you can take withdrawals on your own schedule — no forced distribution. This is almost always better than a lump-sum payout, which would trigger ordinary-income tax on the entire gain in the year of death.
Continuation is not automatically the right call for everyone. If you need the cash now, or the contract carries high fees and a weak crediting rate, taking the death benefit and reinvesting may serve you better — weigh the deferral against the contract's actual cost.
Qualified (IRA) annuities under the SECURE Act
For inherited qualified annuities (held in an IRA), the SECURE Act of 2019 ended the lifetime stretch for most non-spouse beneficiaries. The new rule: a 10-year distribution window. The whole balance must come out by the end of the tenth year after death. If the owner died before their required beginning date, you choose the timing within that window, so the usual play is to take more in lower-income years and less in higher-income ones. If the owner had already started required minimum distributions, IRS final regulations (effective 2025) also require an annual minimum in years one through nine; you can always take more, but skipping a year triggers the RMD excise tax.
A narrow group of "eligible designated beneficiaries" — surviving spouses, minor children of the owner, disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the owner — can still use their life expectancy instead of the 10-year rule (a minor child only until age 21, then 10 more years). Other individual beneficiaries are on the 10-year clock; an estate, or a trust that is not "see-through," faces the 5-year rule, or the owner's remaining life expectancy if the owner had already started RMDs.
Mistakes to avoid
- Cashing out on autopilot. Taking the default lump sum is the single most expensive error, because it crams every dollar of gain into one tax year.
- Letting the clock run out. The 5-year and 10-year windows start at the owner's death, and on a non-qualified annuity, life-expectancy payments must begin within one year of it. Stall past that mark and only the lump sum or the 5-year rule remains.
- A spouse forgetting to elect continuation. Miss the assumption election and you may be stuck with a taxable death benefit you never needed to trigger.
- Ignoring the contract's fees. Continuing a high-cost annuity just to defer tax can cost more in fees than it saves in tax — read the surrender and rider terms.
- Naming the wrong beneficiary. A trust or estate as beneficiary often loses the friendliest options; review designations with an estate attorney while you still can.
What to do first
- Get the contract and the beneficiary form from the insurer, and confirm whether the annuity is qualified or non-qualified.
- Ask for the cost basis — the gain above basis is what you'll be taxed on, so you need that figure to plan.
- Identify your status: spouse vs. non-spouse, and whether you're an eligible designated beneficiary for IRA annuities.
- Model the timing against your expected income for the next several years before you elect anything.
- Loop in a tax professional or fiduciary advisor right away — the deadline is running, and the best election is hard to reverse.
Do not feel rushed into a payout, but do feel rushed into a decision about how to be paid. The election you make in the first weeks shapes the tax bill for years, and most carriers will not undo it once the money moves.
