Inherited Annuity: Payout Options and How the Tax Works

When you inherit an annuity, what you can do with it, and how much tax you pay, comes down to two questions: are you the deceased owner's surviving spouse, and was the annuity a qualified one held inside a retirement account or a non-qualified one bought with after-tax money. A surviving spouse can usually take the contract over and keep it running untouched. Everyone else chooses from a menu of payout options, and the earnings inside the contract are taxed as ordinary income as they come out. Unlike inherited stocks or property, an annuity gets no step-up in cost basis, so the gain the original owner built up does not disappear at death.

That last point is the one that surprises people, so it is worth stating plainly at the start. An inherited annuity is what the tax code treats as income in respect of a decedent: income the deceased earned but had not yet paid tax on, now passed to you along with the tax bill.

The figures in this article are illustrative examples used to explain the mechanics. They are not quotes, current rates, or guarantees. Annuity contracts, insurer rules, and tax law vary by product and state and change over time, so confirm your own position with the issuing insurer and a tax adviser before acting.

What you actually inherit

An annuity is a contract with an insurance company, and like a life insurance policy it usually names a beneficiary. That designation controls. When the owner dies, the annuity passes directly to the named beneficiary and generally bypasses the will and probate, which is one reason people use them. If no beneficiary is named, the contract typically pays into the estate, which is the worst outcome for both flexibility and tax.

What passes to you is the contract's death benefit, which for a deferred annuity still in its accumulation phase is usually the account value or a guaranteed minimum. For more on how that death benefit is defined, see our guide to the annuity death benefit. Your job as beneficiary is then to decide how to take that money, and the rules for doing so are where the real detail sits.

The first fork: are you the surviving spouse?

The single biggest factor is whether you were married to the deceased owner.

A surviving spouse who is the sole beneficiary can almost always elect spousal continuation. This means you step into the contract as the new owner and keep it going exactly as it was: the tax deferral continues, the account keeps growing untaxed, and nothing is due until you take money out. In effect the annuity is treated as if it had always been yours. This is usually the most valuable option because it postpones the tax and preserves all the future choices.

A non-spouse beneficiary, such as an adult child, cannot continue the contract in the same way. You must instead begin taking the money out under one of the distribution options below, on a timetable the tax rules impose. You can still spread the payments, but you cannot leave the money to grow indefinitely.

The payout options for a non-qualified annuity

If the annuity was non-qualified, meaning it was bought with money that had already been taxed, a non-spouse beneficiary generally chooses from these:

• Lump sum. Take the entire death benefit at once. Simple, but all of the earnings become taxable in a single year, which can push you into a higher bracket.
• The five-year rule. Empty the contract by the end of the fifth year after the owner's death. You are not forced into equal instalments, so you can time withdrawals across those years to manage your tax bracket, then clear the balance before the deadline.
• The non-qualified stretch (life-expectancy payout). If the contract and insurer allow it, take payments over your own life expectancy. This spreads the taxable earnings across many years and is often the most tax-efficient route, though not every insurer offers it and it must generally begin within about a year of the death.
• Annuitization. Convert the death benefit into a stream of guaranteed payments, which brings in the exclusion ratio so part of each payment is treated as a tax-free return of the original cost basis.

A useful rule of thumb: the more slowly you take the money, the more of it you generally keep, because you spread the earnings across more tax years rather than stacking them into one.

How the tax actually works

The taxable portion of an inherited non-qualified annuity is the earnings, the growth above the original owner's cost basis. That basis carries over to you unchanged. Payments come out earnings-first, so early withdrawals are fully taxable as ordinary income until the gain is exhausted, and only then do you reach the tax-free return of basis. This is the same last-in, first-out ordering explained in our guide to how annuities are taxed, and it applies whether the money was qualified or not for the earnings-versus-basis split.

Two features often catch beneficiaries off guard:

• No step-up in basis. When you inherit a taxable brokerage account or a house, the cost basis resets to the date-of-death value and the built-in gain is wiped out. An annuity does not get this treatment. The deferred earnings remain taxable to you.
• The 10% early-withdrawal penalty does not apply. The penalty that normally hits pre-59½ annuity withdrawals is waived on death benefits paid to a beneficiary, whatever your age. So you owe income tax on the earnings but not the extra penalty.

Because the earnings arrive as ordinary income, an inherited annuity can also qualify for an income-in-respect-of-a-decedent deduction if the estate paid federal estate tax on it, a point worth raising with a tax adviser in larger estates.

Qualified inherited annuities are a different set of rules

If the annuity was held inside an IRA or an employer retirement plan, it is a qualified annuity, and the retirement-account inheritance rules take over. The whole distribution is generally taxable, since none of the money was ever taxed, and the SECURE Act's timetable usually applies: most non-spouse beneficiaries must empty an inherited retirement account within ten years. The distinction between a qualified and non-qualified annuity drives almost everything about the tax, and we cover the underlying difference in qualified vs non-qualified annuity. Because a qualified inherited annuity behaves like any other inherited retirement account, the mechanics line up with our companion guide to the inherited IRA rather than with the non-qualified annuity rules above.

Practical points that change the outcome

A few decisions made in the first months matter more than people expect.

Do not cash out on reflex. A lump sum is the default many beneficiaries reach for, and it is often the most expensive choice because it bunches years of deferred earnings into one tax year. If the stretch or five-year options are available, they usually leave you with more after tax.

Check what the specific insurer allows before assuming an option exists. The tax code permits the non-qualified stretch, but not every contract or carrier administers it, and some impose their own deadlines. Ask the insurer in writing.

Mind the election deadlines. Several of these choices, particularly the life-expectancy stretch, must be elected within a set window after the death, often around a year. Miss it and you can be defaulted into the five-year rule or a lump sum. If the annuity is one you are still building rather than inheriting, our overview of what an annuity is and the mechanics of a single premium immediate annuity explain the products these rules attach to.

Frequently asked questions

Do I pay tax on the whole inherited annuity?

Not on a non-qualified annuity. Only the earnings, the growth above the original owner's cost basis, are taxable as ordinary income; the basis itself comes back tax-free. On a qualified annuity held in an IRA or plan, the full amount is generally taxable because none of it was taxed before. Either way the taxable part is ordinary income, not capital gains.

Can I roll an inherited annuity into my own IRA?

Only a surviving spouse can effectively take over the contract or move qualified money into their own retirement account. A non-spouse beneficiary cannot roll a non-qualified inherited annuity into their own IRA; they must take distributions under the payout options the contract and tax rules allow. Confirm the specifics with the insurer.

Is an inherited annuity subject to the 10% early-withdrawal penalty?

No. The 10% penalty that normally applies to annuity withdrawals before age 59½ is waived for death benefits paid to a beneficiary, regardless of your age. You still owe ordinary income tax on the taxable earnings, but not the additional penalty.

What happens if no beneficiary was named?

The annuity usually pays into the deceased owner's estate. That is generally the least favourable outcome: it can drag the money through probate and often forces the fastest and least tax-efficient payout, typically the five-year rule or a lump sum, with none of the spousal or stretch flexibility. Naming and updating beneficiaries avoids this.

This article is educational and not personal financial or tax advice. Annuity rules, insurer practices, and tax law differ by contract and state and change over time. Confirm your own position with the issuing insurer and a qualified tax adviser before making a decision.