Are Annuities Really Taxable When Inherited? Avoid this Mistake + FAQs

Yes, inherited annuities are usually taxable to the beneficiary.

Inheriting an annuity can provide a financial windfall, but it often comes with complex tax obligations.

Beneficiaries must navigate federal tax rules and sometimes state taxes to understand what they owe.

This expert guide breaks down everything you need to know – from federal vs. state tax treatment, to different inheritance scenarios, to key terms, pitfalls, and legal nuances – so you can handle an inherited annuity like a pro.

In this article, you will learn:

• Federal tax rules for inherited annuities and how the IRS treats annuity death benefits as ordinary income (not capital gains).

• State-level tax nuances – including a 50-state comparison table – covering state income tax, estate tax, and inheritance tax implications for annuity beneficiaries.

• The differences between inheriting a non-qualified annuity vs. an IRA annuity (qualified annuity), and how each is taxed.

• How payout options (lump sum vs periodic payments like the 5-year rule, 10-year rule, or life annuitization) affect the taxes you’ll owe.

• Common inheritance scenarios (spousal continuation, non-spouse beneficiary, trusts) with examples and tables illustrating tax outcomes.

• The pros and cons of inheriting an annuity (💡 hint: tax-deferred growth vs. income tax burden) in a handy comparison table.

• Definitions of key terms (e.g., stretch provision, death benefit, RMDs, etc.), mistakes to avoid, real-world examples, comparisons to other inheritances, and relevant court rulings that shape the taxation of inherited annuities.

Inherited Annuity Taxation 101: Federal Rules and Quick Answer 🏦

In most cases, inherited annuity payments are taxable under federal law. The IRS considers the untaxed earnings in an annuity as income in respect of a decedent (IRD).

This means any gains that accumulated tax-deferred in the annuity become taxable income to whoever inherits the contract. Unlike some inherited assets (for example, stocks or real estate) that receive a step-up in cost basis at death, annuities do not get a step-up in basis.

The beneficiary inherits the annuity’s original cost basis (the amount the original owner paid in). As a result, any growth above that basis is generally taxable as ordinary income when received by the beneficiary.

Why Inherited Annuities Are (Usually) Taxable 🔎

Annuities are unique because they often contain a mix of principal (after-tax contributions in a non-qualified annuity or pre-tax funds in a qualified annuity) and earnings.

When the original owner dies, the contract’s remaining value – often paid as a death benefit – transfers to the beneficiary.

Critically, any untaxed earnings inside the annuity retain their tax-deferred status only until they are paid out. The IRS doesn’t let that tax-deferred growth go untaxed forever. As soon as the beneficiary starts receiving money, those previously untaxed gains must be reported as income.

• If you inherit a non-qualified annuity (purchased with after-tax dollars), the original premium paid by the owner is tax-free return of basis to you, but all earnings are taxable. For example, if your parent invested $50,000 (after tax) into an annuity and it’s worth $80,000 at death, you have $30,000 of taxable income embedded in it.

• You won’t pay tax on the $50,000 original investment (the basis), but the $30,000 gain will be taxed when withdrawn.

• If you inherit a qualified annuity (for instance, an annuity inside an IRA or 401(k) – often called an IRA annuity), then 100% of the distributions are taxable as ordinary income. This is because the original contributions were pre-tax (or tax-deductible) and no taxes were paid on the growth. Essentially, an inherited IRA annuity is treated like an inherited IRA: the entire amount is taxable upon distribution (except in rare cases of after-tax contributions in a qualified plan).

In short, the federal answer to our question is clear: Yes – expect to pay income taxes on an inherited annuity, at least on the gain portion. The IRS does not impose any inheritance tax at the federal level (there’s no federal “inheritance” tax, only estate tax on very large estates), but it will impose income tax on annuity payouts you receive.

These payouts are taxed at your ordinary income tax rate (whatever bracket you fall into in the year you receive the income). They are not taxed at capital gains rates, because annuity earnings are considered ordinary income (similar to interest or wages for tax purposes).

Federal Tax Treatment: Ordinary Income, No Capital Gains 🚨

It’s important to understand how the IRS taxes annuity distributions for beneficiaries. Inherited annuity payments are taxed as ordinary income.

This means if you receive a payout from an inherited annuity, that amount gets added to your other income for the year (salary, etc.) and taxed at your regular tax rate. There is no special lower tax rate for these payments (unlike long-term capital gains or qualified dividends).

Why not capital gains? Because the growth in an annuity isn’t treated like a capital asset sale – it’s considered deferred personal income of the original owner. In fact, the tax code treats the untaxed gain in an annuity as if the original owner would have paid ordinary income tax on it, had they withdrawn it. When they die and you inherit it, you step into their shoes for tax purposes.

The concept of Income in Respect of a Decedent (IRD) under the tax code (IRC §691) ensures that just because the owner died, the IRS still gets to collect the income tax that was deferred. Translation: the earnings portion of an inherited annuity is taxable to the beneficiary just like it would have been to the owner.

However, note that no 10% early withdrawal penalty applies to inherited annuities. The IRS waives the usual 10% penalty for withdrawing from an annuity (or retirement account) before age 59½ in the case of death distributions.

So if, say, a 30-year-old inherits an annuity and takes a distribution, they will pay income tax on it but won’t owe the extra 10% penalty (that penalty is designed to discourage early withdrawals by the original owner, not to penalize beneficiaries of a deceased owner).

Spousal vs. Non-Spousal Beneficiaries: Special Rules ❤️

Federal tax law provides special flexibility for a spouse beneficiary of an annuity. If you are the surviving spouse and you inherit your husband’s or wife’s annuity, you usually have an option to do a spousal continuation.

This means you can step in as the new owner of the annuity contract without triggering an immediate taxable event. The annuity essentially continues as if you were the original owner – tax-deferred growth carries on, and you can even name new beneficiaries for when you pass.

There is no immediate income tax due when a spouse continues the annuity; taxes will be due later when the spouse (now owner) takes withdrawals from the annuity.

For example, imagine Jane inherits a deferred annuity from her late husband. If Jane is the sole beneficiary and the contract allows spousal continuation (most do, per IRS rules), she can elect to continue the annuity in her own name.

All the same tax-deferral benefits remain and no withdrawal is required on a specific timeline (for non-qualified annuities, there’s no required minimum distribution rule for owners). Jane could even add funds (depending on contract terms) or just let it grow until she needs it. When she eventually withdraws money, those withdrawals will be taxed as her income (on the gain portion), just as if the annuity had always been hers.

Non-spouse beneficiaries (e.g., children, siblings, or anyone other than the spouse) do not have this continuation privilege in the same way. A non-spouse cannot simply become the owner and let the annuity keep growing indefinitely. The IRS requires non-spouse beneficiaries to distribute the annuity within certain timeframes (discussed below in the payout options section).

A non-spouse beneficiary will have to choose one of the post-death payout options, which will determine how quickly the funds come out and thus how quickly taxes are paid. But rest assured, one way or another, the IRS expects those deferred earnings to be taxed in due course.

One more note: if you inherit an IRA annuity (an annuity inside a qualified retirement account) as a spouse, you have a similar but slightly different option – you can do a spousal rollover of the IRA. That means you roll the inherited IRA annuity into your own IRA (or even keep it as inherited IRA, depending on what’s more beneficial).

In practice, many surviving spouses elect to treat an inherited IRA as their own IRA, especially if they are over the IRA distribution age, so they can delay distributions until their own required age. In a spousal rollover of an IRA annuity, the annuity contract might continue under your ownership or be transferred to a new annuity contract in your name.

The key is that no immediate income tax is due; the money stays in a tax-deferred IRA wrapper. Future withdrawals will be taxed as your income when they occur.

Tax Reporting and IRS Forms 📝

If you inherit an annuity and receive distributions, the insurance company will issue you an IRS Form 1099-R for the year of distribution. This form reports the gross distribution and the taxable amount of that distribution.

For example, if you took a $50,000 lump-sum distribution from an inherited non-qualified annuity that had $40,000 in gain, the 1099-R would likely show $50,000 distributed and $40,000 taxable (the $10,000 difference is the return of the original owner’s basis, which is not taxed). You’ll use this 1099-R info to report the income on your federal tax return.

Be aware that large distributions from an inherited annuity can bump you into higher tax brackets. The IRS doesn’t have a special rate for inherited annuity income – it just piles on top of your other income. So part of good planning is considering whether you want to spread out the distributions over several years to manage your tax bracket (more on that in the payout options section).

In summary, federal tax treatment of inherited annuities in a nutshell: tax-deferred in the contract, but taxable as ordinary income when paid to beneficiaries. Spouses can defer this taxation further via continuation or rollover, while non-spouses have to start drawing down the account under IRS rules. Now, let’s turn to the state side of things – because federal taxes aren’t the only taxes that might apply.

State Tax Implications: Does Your State Want a Cut? 🗺️

Beyond federal taxes, you’ll want to consider state taxes on an inherited annuity. There are two layers to consider at the state level: state income tax on the annuity payouts, and state estate or inheritance taxes related to the transfer of the annuity from the decedent to you. These are very different taxes with different rules:

• State income tax: Most states that have an income tax will tax annuity distributions as part of your ordinary income, just like the IRS does. If you live in a state with income tax, any taxable amount you withdraw from an inherited annuity will typically be included in your state taxable income. However, some states offer special exclusions or deductions for retirement income (pensions, IRAs, annuities), which might reduce or eliminate the state tax on an inherited annuity distribution. And a handful of states have no income tax at all, which means no state income tax on your annuity inheritance.

• State estate tax or inheritance tax: These are taxes not on the income, but on the transfer of wealth at death. A state estate tax is imposed on the estate of the decedent (before assets pass to heirs) if the total estate value exceeds a certain threshold – it’s paid out of the estate’s assets. A state inheritance tax, by contrast, is imposed on the beneficiary for the privilege of receiving an inheritance, and the rate can depend on your relationship to the decedent. Only a few states impose inheritance taxes, and they often exempt close relatives like spouses (and sometimes children). In states with inheritance tax, an inherited annuity’s value could be subject to that tax.

To give you a comprehensive view, we’ve compiled a state-by-state summary of relevant taxes affecting inherited annuities. The table below outlines for all 50 U.S. states: whether the state has an income tax on annuity payouts (and any special retirement income rules), whether the state has its own estate tax, and whether it has an inheritance tax:

How to use this table: If you’re a beneficiary, look up the state where you reside (since that’s typically where you’ll owe income tax on your inheritance income). Also consider the decedent’s state: for estate or inheritance tax, it’s usually the decedent’s state of residence that matters. For example, if your parent lived (and died) in Pennsylvania, their estate (or you as beneficiary) might owe Pennsylvania inheritance tax on the annuity’s value even if you live out of state. On the other hand, state income tax on the payouts will generally be owed to your state of residence when you receive the payments.

A few takeaways from the state comparison:

• Only six states impose a inheritance tax (Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania). Maryland and New Jersey exempt children; Pennsylvania does tax children (4.5%). Spouses are exempt in all these states. Keep inheritance tax in mind if you inherit from someone in those states – you might owe a percentage of the annuity’s lump-sum value to the state, separate from any income tax on the payouts.

• Estate taxes are separate and only hit very large annuities as part of a large estate. For 99% of people, federal estate tax won’t apply (federal exemption is over $12 million per person until 2025). But states like Massachusetts or Oregon have low estate tax thresholds (~$1M) – if the deceased’s total estate, including the annuity, exceeds that, the estate might owe tax. That estate tax would be handled by the executor, not directly by the beneficiary, but it can reduce what you inherit.

• If you live in a no-income-tax state (Florida, Texas, etc. 😎), congratulations – your inherited annuity payouts won’t be taxed at the state level, only federal.

• Some states are very retiree-friendly (like Illinois, Mississippi, Pennsylvania) and do not tax retirement distributions at all. If your inherited annuity counts as a retirement distribution under their rules, you might avoid state income tax. For instance, Illinois doesn’t tax IRA, 401k, or pension income – which would include an annuity payout from those sources.

• Always double-check current state laws or consult a CPA in your state, because state tax laws change. The table provides a general guide (as of mid-2025) to state tax nuances for inherited annuities.

Now that we’ve covered Uncle Sam and the states, let’s dive into how different types of annuities and payout choices affect taxation.

Qualified vs. Non-Qualified Annuities: Why It Matters 🏷️

Not all annuities are created equal in the eyes of the tax code. A key distinction is whether the annuity is qualified or non-qualified. These terms refer to the annuity’s status relative to tax-advantaged retirement plans:

• Qualified Annuity (Tax-Qualified): This is an annuity contract that is part of a tax-qualified retirement plan. Common examples include an annuity within an IRA, a 401(k) annuity option, or a 403(b) TSA annuity. These annuities are funded with pre-tax dollars (or grew tax-deferred in a retirement plan). All the money in such an annuity is untaxed until withdrawn. Therefore, when inherited, a qualified annuity’s distributions are fully taxable (every dollar is taxed as income) because none of it has been taxed before. You might hear the term IRA annuity to refer to an annuity held in an Individual Retirement Account – that falls under this category.

• Non-Qualified Annuity: This is an annuity purchased outside of a retirement plan, with after-tax money. For example, your parent buys a deferred annuity from an insurance company with a lump sum of savings – that’s a non-qualified annuity. These annuities have a cost basis (the after-tax amount invested) and any growth above that is untaxed until withdrawal. When a non-qualified annuity is inherited, the beneficiary will only be taxed on the earnings, not on the original investment amount (since that was from after-tax funds). Non-qualified annuities are common estate planning tools because they offer tax-deferred growth without contribution limits, but they do come with this future tax liability for heirs.

Why this matters: The taxation of inherited distributions differs slightly between these two:

• With a qualified annuity, every bit of the distribution is ordinary income. It doesn’t matter if the original owner was 90 and taking distributions or if they never touched it – the entire amount coming out is taxable (except if the original owner made nondeductible contributions, which is uncommon for annuities in plans).

• With a non-qualified annuity, the beneficiary needs to be aware of the exclusion ratio or interest-first rules that apply. If the beneficiary takes a lump sum or periodic withdrawals from the contract, the IRS uses an “income-first” rule (LIFO – last in, first out) for non-qualified annuities. That means the earnings portion comes out first and is taxed first. If instead the beneficiary annuitizes the payout (converts it to a stream of regular payments over life or a fixed period), then each payment is split pro-rata into a taxable portion (earnings) and a nontaxable portion (return of basis) using an exclusion ratio formula. In practical terms, annuitizing an inherited non-qualified annuity spreads the taxable income over many years, whereas taking withdrawals could front-load the taxable income.

Let’s illustrate the difference: Suppose you inherit an annuity worth $100,000. Case A: It’s a qualified annuity (say an IRA annuity). If you cash it out, you have $100,000 of taxable income. Case B: It’s non-qualified; original owner paid $60,000 into it (basis) and it’s now $100,000. If you cash it out, you have $40,000 of taxable income (the gain). If you instead choose to receive payments over, say, 20 years, roughly 40% of each payment would be taxable and 60% would be tax-free return of basis (until the basis is fully recovered, after which 100% of remaining payments become taxable).

Another important point: Required minimum distributions (RMDs). Qualified annuities (if in an IRA or retirement plan) were subject to RMD rules for the original owner (typically starting at age 72 or 73). When inherited, those turn into rules like the 10-year rule (for most non-spouse beneficiaries, explained in the next section) or life expectancy withdrawals if an eligible beneficiary. Non-qualified annuities, on the other hand, are not subject to RMDs during the owner’s life, but after the owner’s death, the IRC Section 72(s) kicks in requiring that the funds do not remain in the contract indefinitely. Section 72(s) basically says a non-qualified annuity must be distributed within 5 years of death, unless the beneficiary elects to take distributions over their life expectancy (and begins within 1 year of death). So both qualified and non-qualified annuities have rules preventing indefinite deferral after death – but the specifics differ.

Spousal exception: If the beneficiary is a spouse, these distinctions blur a bit because a spouse can continue either type. A spouse can roll a qualified annuity (IRA) into their own IRA (continuing deferral), or continue a non-qualified annuity contract as their own and not be forced into the 5-year or life expectancy rule (they essentially become the new owner, and the 72(s) requirements apply only upon their subsequent death). So the qualified vs non-qualified issue is most crucial for non-spouse beneficiaries who have to decide how to take the inherited annuity payouts.

Key takeaway: Know what type of annuity you inherited. If it’s part of an IRA or retirement plan, plan for full taxation and the 10-year rule (coming up next). If it’s non-qualified, figure out the cost basis vs gain and understand your distribution options (lump sum, 5-year, stretch) to minimize the tax hit.

Lump Sum vs. Periodic Payments: How Your Payout Choice Impacts Taxes 💸

When you inherit an annuity, one of the most important decisions is how you receive the money. Beneficiaries are often presented with several payout options. The choice you make will directly affect when and how much tax you pay. The main options typically include:

• Lump Sum – Take all the proceeds at once.

• Five-Year Rule (or Ten-Year Rule) – Take distributions over a fixed period (five or ten years) as you see fit, as long as the entire balance is paid out by the end of that period.

• Life Expectancy Payments (Stretch or Annuitization) – Take at least annual payments spread over your remaining life expectancy (this could be via a structured withdrawal schedule or formally annuitizing into a lifetime income stream).

• Spousal Continuation (if you’re a spouse) – Keep the annuity intact (no immediate distribution; effectively treating it as your own annuity).

Let’s break down the tax implications of lump sum vs. periodic payouts:

Taking a Lump Sum 💰

Opting for a lump sum means you withdraw the entire cash value of the inherited annuity in one go. The advantage is simplicity – you get all the money and can use or invest it as you wish. However, tax-wise, this can be brutal in the short term:

• Tax Impact: All the taxable gain in the annuity becomes income in one tax year. This often means a large spike in your taxable income. It could push you into a higher federal income tax bracket for that year. For example, inheriting a $200,000 annuity with $100,000 of gains and cashing it out means adding $100k to your income in one year. If you already earn $100k from work, now you’re taxed as if earning $200k, potentially hitting a much higher bracket.

• Pros: You have full control of the funds immediately. You can pay off debts, invest in other assets, or make large purchases. If the annuity has high fees or poor investment options, taking the money out might be wise to invest elsewhere. Also, if the annuity is small or the gains are minimal, the tax hit might not be too bad in absolute terms.

• Cons: A big lump sum is usually the least tax-efficient method. You might lose a good chunk of the inherited value to taxes in that single year. Plus, you’ll miss out on the continued tax-deferred growth the annuity could offer if you kept it longer.

When might a lump sum make sense? Perhaps if the annuity value is modest or if you have pressing needs. Also, if the annuity contract is complicated (maybe a variable annuity you don’t want to deal with) or if it has a death benefit rider that gives you a bit extra at death (so you got more than cash value), you might take the money and run, tax be damned. Just go in with eyes open about the tax bill. One more thing: if the annuity had any surrender charges still in effect, check if they’re waived at death (many contracts waive surrender fees when paying a death benefit; but if not, a lump sum could incur those charges too).

Using the 5-Year or 10-Year Rule ⏳

Many annuities (and by law, all non-qualified annuities per IRC 72(s)) offer a five-year rule option. Under this rule, you have to withdraw the entire annuity value by the end of the fifth year following the owner’s death. You have flexibility how you do it in that timeframe – it could be a little each year, nothing for four years and everything in year five, or any combination. The Secure Act of 2019 introduced a similar concept – a 10-year rule – for inherited IRAs and other retirement accounts when the beneficiary is not an “eligible” beneficiary. Some annuity contracts have mirrored that 10-year rule for certain qualified annuities. In essence, the 5-year rule applies to non-qualified annuities (unless life-expectancy distributions are chosen), and the 10-year rule now applies to most inherited qualified annuities (IRAs) for non-spouses.

Tax Impact: By using a multi-year rule, you can spread the taxable income over several years instead of one. This can prevent bracket creep. Using our earlier example of $100k gain, instead of $100k in one year, you might take $20k of taxable income per year over 5 years. That could keep you in a lower bracket each year. However, note that during the deferral, the annuity may continue to grow, creating more taxable earnings. The compounding can slightly increase the total taxable amount if the account grows after the original owner’s death. Still, you retain some tax deferral by not taking all money out immediately.

Strategy: You don’t necessarily have to take equal amounts each year. Some beneficiaries take smaller distributions in years when their own income is high, and larger ones when their income is lower, as long as it’s all out by the deadline. The rules typically allow flexible timing, so you could, say, wait a couple years, then take distributions in years 3, 4, 5 if that suits you.

5 vs 10 years: If it’s a non-qualified annuity, you likely have 5 years (unless the contract allows stretch over life). If it’s an inherited IRA annuity and you’re a non-spouse, you generally have 10 years (due to the SECURE Act’s rules for designated beneficiaries). The principle is similar – by end of the period, account drained. The 10-year rule for IRAs does not require equal distributions, but if the original owner was already taking RMDs (i.e., died after their required beginning date), the IRS currently requires beneficiaries to take annual minimum distributions in years 1-9 as well, in addition to emptying by year 10. (This has been a point of confusion and evolving IRS guidance, but as of 2023 the IRS expects non-eligible beneficiaries to take yearly distributions if the decedent was in RMD phase.)

Pros: More control over timing than annuitizing; continued tax-deferred growth on the undistributed amount in the interim; can fit distributions to your life events (maybe delay while you’re working, take more when retired within that period, etc.). Cons: You can’t stretch beyond that period – eventually you must take all money and pay taxes. Also, you need to be disciplined to not forget to withdraw everything by the deadline – missing the 5-year or 10-year deadline could result in unpleasant tax penalties (potentially the remaining amount being treated as distributed in a lump sum anyway).

Life Expectancy “Stretch” or Annuitization 📆

Another option (if allowed by the contract and IRS rules) is to stretch payments over your life expectancy. This is often done by choosing to annuitize the inherited annuity or by taking required minimum distributions based on life expectancy. Prior to 2020, “stretch IRA” was a popular strategy for inherited IRAs, allowing the beneficiary to take RMDs based on their life expectancy (often decades long, greatly deferring taxes). The SECURE Act curtailed this for most beneficiaries (except “eligible designated beneficiaries” like spouses, minor children, or disabled heirs who can still stretch). However, for non-qualified annuities, a stretch option is still generally allowed if you start within one year of death.

Annuitization: You tell the insurance company, “pay me over my lifetime” (or a fixed period longer than 5 years). They calculate a regular payment. Each payment will be part taxable, part tax-free (return of basis) if non-qualified, or fully taxable if qualified. The taxable portion is spread out according to an exclusion ratio (for non-qualified) so that you only pay tax gradually. If you outlive the actuarial expectancy (i.e., you receive more payments than expected), at some point you’ll have recovered all basis and then payments thereafter become fully taxable.

Stretch via RMD withdrawals: Some non-qualified annuities allow you to elect to take withdrawals based on your life expectancy without formally annuitizing (sometimes called a “stretch annuity” distribution option). For example, if you are 50 years old, your life expectancy per IRS tables might be ~34 years. You can withdraw an amount each year as if an RMD from a retirement account (often the contract will calculate it for you), which effectively empties the account over your lifetime. If you die before it’s emptied, your beneficiary can continue the stretch. This approach keeps the remaining funds growing tax-deferred, and you only pay tax on the smaller annual withdrawals.

Pros: Maximum tax deferral. You only pay a little tax each year, potentially keeping you in a low bracket. The annuity continues to grow tax-deferred on the undistributed balance. If you don’t need the money all at once, this can be a great way to let the inheritance continue to grow for you, akin to an inherited IRA stretch. It can also provide a steady stream of income (some beneficiaries treat it like an extra pension).

Cons: Less flexibility – once you annuitize, you typically can’t change your mind (the payments are fixed). With life expectancy withdrawals, you could take more than the minimum if needed, but you are somewhat committing to a long-term plan. Also, if the annuity’s investments underperform or you have other needs, you might regret not cashing out earlier. And always remember: the tax will eventually be paid. If you live a long time, you’ll end up paying tax on all those earnings in dribs and drabs over many years (which is fine, but just to note, it doesn’t escape tax, it delays it).

Additionally, the SECURE Act’s 10-year rule for inherited IRAs means most non-spouse beneficiaries of qualified annuities can no longer stretch over life (unless they fall into an exception category). So stretching is mostly a concept now for non-qualified annuities or eligible beneficiaries of IRAs (like a minor child until majority, or a disabled beneficiary, etc.).

Let’s recap these payout methods and their effects in a quick comparison table:

As you can see, how you inherit is almost as important as what you inherit when it comes to annuities. A savvy plan can save significant taxes. Many beneficiaries consult with a financial advisor or CPA before choosing a payout method, to weigh the options given their personal financial situation and the tax implications. There is no one-size-fits-all answer – someone in a high tax bracket might lean toward stretching payments, whereas someone who needs cash now might accept the tax cost of a lump sum.

The “Stretch” Provision: Past Strategies vs. Current Rules 📜

You may have heard the term “stretch annuity” or “stretch IRA” in estate planning discussions. This refers to the strategy of extending (stretching) the payout of an inherited account over the beneficiary’s lifetime to maximize tax deferral. Let’s clarify this concept and how recent law changes have affected it:

The Old Days of Stretch IRA (Pre-2020)

Before 2020, if you inherited an IRA or other retirement account, you were generally allowed to take distributions over your life expectancy. This was informally called the stretch IRA strategy. For example, a 40-year-old who inherited an IRA could withdraw maybe 1/43 of the account the first year (based on IRS tables), then 1/42 of what’s left the next year, and so on – theoretically stretching distributions for decades. Many beneficiaries loved this because the bulk of the account could stay invested and growing tax-free for a long time.

Non-qualified annuities likewise often allowed a stretch: IRS rules required distribution in 5 years or life expectancy. Most people opted for life expectancy payouts, effectively stretching the annuity. Some insurance companies even marketed “Inherited IRA annuities” or “Stretch annuities” designed to facilitate this, automatically calculating annual required distributions for the beneficiary.

The SECURE Act and the 10-Year Rule (New Reality)

In late 2019, Congress passed the SECURE Act, which upended the stretch strategy for inherited retirement accounts. For IRA or 401k owners who died in 2020 or later, most non-spouse beneficiaries now must use the 10-year rule (meaning the entire account must be emptied by the end of 10 years after death). The only people exempt from this (who can still stretch) are called “Eligible Designated Beneficiaries” (EDBs). EDBs include:

• Surviving spouses (they have even more options – usually they do a spousal rollover instead of stretch),

• The decedent’s minor children (until they reach age of majority, after which the 10-year clock starts),

• Disabled individuals (as defined by tax law criteria),

• Chronically ill individuals,

• Individuals not more than 10 years younger than the decedent (often siblings around the same age).

If you fall into one of those categories, you can still choose to stretch an inherited IRA over life expectancy. If not, you’re stuck with 10-year. For example, if you inherit an IRA from your parent in 2025 and you’re 45, you have until the end of 2035 to withdraw it all. You could still mimic a stretch by taking a little each year (nothing stops you from doing life-expectancy-like withdrawals voluntarily), but by year 10 you must drain the account.

What about non-qualified annuities? The SECURE Act did not directly change rules for non-qualified annuities, since it focused on retirement plans. So, for annuities outside of IRAs, the old stretch provision via life expectancy is technically still available to non-spouse beneficiaries. However, not all insurance companies may offer a life expectancy payout option – though many do, often calling it a “stretch payout” or “annuity stretch option.” If they don’t, the default is the 5-year rule. It’s worth asking the insurer if a life payout is an option for a non-spouse beneficiary. Often, if the original owner had not annuitized yet, the beneficiary can choose to annuitize over their life, which accomplishes a similar result.

Legislative environment: The elimination of the stretch for IRAs was a big change (essentially a revenue-raiser for the government, forcing faster taxation). Some beneficiaries who were counting on multi-decade stretches had to adjust. There have been some clarifications via IRS regulations (like whether annual distributions are required within the 10 years – as mentioned earlier). Always check the latest rules or IRS guidance if you’re inheriting a retirement account annuity, as the details can evolve.

In summary, the “stretch provision” isn’t a formal rule but a nickname for the ability to defer. It still exists in limited forms: spouses can always defer (even more than stretch, by just continuing the account), eligible beneficiaries can stretch IRAs, and non-qualified annuity beneficiaries can stretch via life payouts if available. But for most adult children inheriting IRAs, the stretch is gone – replaced with the 10-year rule. As a result, many people are taking a hybrid approach: perhaps taking some money out gradually over the 10 years (a “semi-stretch”), rather than waiting and taking it all in year 10 (which could be a huge tax bomb).

Now, having covered the rules and options, let’s ground this in concrete scenarios with examples. Below, we’ll explore three common inheritance scenarios and how the taxes might play out for each.

Common Inherited Annuity Scenarios (With Examples) 🔍

To make this information more digestible, let’s walk through a few typical scenarios that financial advisors, estate attorneys, and CPAs often see. We’ll outline the situation, the beneficiary’s choices, and the tax outcomes for each scenario.

Scenario 1: Spouse Inherits a Non-Qualified Deferred Annuity ❤️

Situation: John Doe, age 75, owned a non-qualified deferred annuity (not in an IRA) that he bought with after-tax money. When John passes away, the annuity is worth $200,000; John’s cost basis (what he paid in) was $150,000 (so there is $50,000 of gain that has never been taxed). John’s wife, Mary (age 72), is the sole beneficiary of the annuity.

Mary’s Options: Being the spouse, Mary has unique options:

1. Spousal Continuation – Mary can elect to continue the annuity contract in her own name, as if she were the original owner. No distribution is required. The $200,000 stays invested in the annuity, and Mary can defer withdrawals until she needs the money. The $50,000 gain remains untaxed until Mary withdraws something.

2. Lump Sum or 5-Year – Mary could also choose to simply cash out now (lump sum) or take the money within 5 years, but those options would trigger taxes on the $50,000 gain.

3. Annuitize for Life – She could convert the $200,000 into a lifetime income stream, say a life annuity payout with a period certain, which would pay her a monthly amount for life. Each payment would be mostly untaxed return of basis until that $150k basis is recovered, and partially taxable interest.

Mary likely doesn’t have to do anything immediately; spousal continuation is often the default if she does nothing or if she proactively elects it.

Tax Outcome: Mary’s choice will determine the tax:

Analysis: Mary likely chooses spousal continuation, especially if she doesn’t need extra income right now. It gives her maximum flexibility and continues tax deferral – a big perk reserved for spouses. She can always later decide to take a lump sum or annuitize or whatever on her own timeline. If Mary needed funds for living expenses, she might annuitize to create a pension-like income, gaining the benefit of an exclusion ratio (only part of each payment is taxed). The lump sum is the least attractive for her unless she desperately wants to invest the money elsewhere, since it would slam her with a $50k taxable income at once. The key here is: spouses have the power to defer taxes, and Mary uses it.

Scenario 2: Non-Spouse Beneficiary Inherits a Non-Qualified Annuity 🎁

Situation: Susan, age 50, inherits an annuity from her father, who passed at age 80. It’s a non-qualified variable annuity (after-tax purchase). The contract value at death is $120,000. Her father paid $100,000 into it (basis), and it has $20,000 of investment gains. Susan is not a spouse (say she’s the daughter). The annuity was still in deferral (her dad hadn’t annuitized; he was taking partial withdrawals but not the whole thing).

Susan’s Choices as a non-spouse:

1. Five-Year Rule – She can keep the money in the annuity account for up to 5 years. Anytime within those 5 years, she can take distributions however she wants, as long as by the end of year 5 the account is empty.

2. Life Expectancy Stretch – If the insurance company allows, she can elect to take distributions over her life expectancy. At 50, her IRS life expectancy might be ~34 years. She’d withdraw a calculated amount each year, effectively “stretching” the payments. This might involve formally annuitizing over a period certain or using a systematic withdrawal plan.

3. Lump Sum – She can simply take the $120k now in one fell swoop.

4. (No spousal continuation option since she isn’t a spouse. If she doesn’t make a choice, many annuity contracts default to the 5-year rule for non-spouse.)

Let’s compare these for Susan:

Outcome: If Susan doesn’t need the money urgently, she might opt for a stretch or 5-year strategy to keep more of the money growing and manage her tax hit. The lump sum in this scenario isn’t actually that bad tax-wise ($20k of income one time), but why pay it all at once if she can defer? By carefully planning, she could maybe recognize $5k of income each year for 4 years (to get that $20k taxed) and then take the rest. Alternatively, if she likes the idea of a guaranteed income, she could annuitize to a life income – but at 50, she might not want to lock into that. Often, non-spouse beneficiaries with moderate sized annuities like this will use the 5-year rule but try to defer as much as possible toward year 5, perhaps taking smaller withdrawals initially.

Scenario 3: Non-Spouse Inherits a Qualified Annuity (IRA) – The 10-Year Rule ⏳

Situation: David, age 60, passed away in 2025. He had a traditional IRA annuity (an annuity contract within his IRA) valued at $300,000. The beneficiary is his 35-year-old daughter, Lisa. Because this is within an IRA, the entire $300k was pre-tax. David was taking RMDs already (he was past 73). Lisa inherits the IRA (not as a spouse, obviously).

Under the SECURE Act rules, Lisa as a non-eligible beneficiary must use the 10-year rule. She has until the end of 2035 to withdraw all funds from the inherited IRA. Additionally, because David died after beginning RMDs, Lisa is required to take RMDs each year 1 through 9 of the 10-year period, based on her life expectancy, in addition to emptying by year 10. (If David had died before RMDs were required, she could have taken nothing until year 10 if she wanted.)

Lisa’s Options within those rules:

• She can keep the annuity contract intact within the inherited IRA for up to 10 years, letting it grow tax-deferred. She must take at least the annual RMD amount (year 1-9, which the insurance company or custodian will calculate based on her age – roughly like 1/~48 of the account at 35, then 1/47, etc., meaning maybe ~2% of the account the first year).

• She can withdraw more than the minimum in any year, even the entire amount at any time, as long as by year 10 it’s all out. She could, for instance, take some each year or even wait and take the bulk in year 10 (though waiting until year 10 still requires those small annual RMDs in years 1-9 in this case).

• If the annuity offers it, she might annuitize the IRA over her lifetime. But annuitization in an IRA doesn’t bypass the 10-year rule (unless she’s an eligible beneficiary, which she is not). Actually, this gets tricky: if she annuitized for life, IRS might consider that meeting the distribution requirement (since a life annuity for a non-eligible beneficiary might not be allowed beyond 10-year rule’s intent – likely the contract would structure a 10-year certain period or something to comply).

• She cannot roll it over into her own IRA (only spouses can do that). It remains an Inherited IRA.

Tax Consequences for Lisa: Any distribution Lisa takes from this inherited IRA annuity is fully taxable (there’s no basis – all pre-tax). If she took all $300k at once, it’s $300k of income (not advisable!). If she stretches over 10 years, she can spread that $300k of income over that time.

Let’s say Lisa decides to take roughly equal withdrawals over 10 years. That’d be about $30k/year (plus whatever growth occurs, but we’ll ignore growth for simplicity). $30k a year added to her income – that might be manageable given she’s 35 (depending on her job, etc.). And those annual RMDs ensure she at least takes some out.

Another strategy: She might take smaller distributions in the early years and more later (or vice versa) depending on her circumstances. For example, if she plans to retire or cut back work at age 40, she might defer more until years 6-10 when her own income is lower.

One thing with inherited IRAs: there’s no 10% penalty regardless of her age, so she has no penalty for taking money before 59½.

We can summarize a possible plan:

Outcome: Lisa will pay tax on $300,000 over the next decade no matter what. The main question is scheduling those taxes. Since she’s relatively young and presumably in her prime earning years ahead, spreading evenly might avoid any one year being ruinous. Also note: If the annuity had any special riders (like guaranteed growth or death benefit enhancements), keeping it for a while might have benefits. Otherwise, she might even decide to transfer the inherited IRA annuity to a different IRA or different investment (via a direct trustee-to-trustee transfer to an inherited IRA brokerage account, or using a 1035 exchange to another annuity if allowed for inherited contracts – the IRS now does allow 1035 exchanges for inherited non-qualified annuities; for inherited IRAs, she could cash it to the inherited IRA and reinvest in other assets).

One more nuance: If Lisa were an “eligible beneficiary” (say Lisa was disabled, or if it was David’s sister who’s only 5 years younger, etc.), then she could choose life expectancy payments instead of 10-year. But in our scenario she’s not, so 10-year it is.

These scenarios highlight that inherited annuity taxation can vary widely. Spouses like Mary have the luxury of deferral; non-spouse like Susan with a non-qualified annuity have to navigate interest-first taxation but can stretch somewhat; and non-spouse like Lisa with a qualified annuity deal with the new 10-year rule.

Next, we’ll step back and consider generally the pros and cons of inheriting an annuity, since it’s not all good or all bad.

Pros and Cons of Inheriting Annuities 👍👎

Inheriting an annuity comes with a mix of advantages and drawbacks. It’s money (that’s good!), but it has strings attached in the form of tax rules and possibly other restrictions. Below is a summary of the key pros and cons, which can help advisors and beneficiaries alike weigh their planning decisions:

In short, inheriting an annuity is a mixed bag. It’s certainly better to inherit an annuity than nothing at all, but compared to some other assets, annuities come with more strings attached. For professionals advising clients, the pros and cons help determine whether an annuity is a good estate planning vehicle. For instance, someone might opt for life insurance instead of an annuity if the goal is to leave a tax-free lump sum. Conversely, an annuity could be suitable for someone who wants to leave their spouse a guaranteed income with the ability to defer taxes.

Next, let’s clarify some of the key terms and concepts that often come up in these discussions, so you can navigate the jargon effectively.

Key Terms and Concepts 🔑

Understanding inherited annuities means wrapping your head around some specific financial and tax terminology. Here’s a glossary of key terms and concepts:

• Annuitant: The person on whose life the annuity’s payouts are based. Often the owner is also the annuitant. When the annuitant (who is usually the owner in these cases) dies, death benefits trigger.

• Beneficiary: The person or entity designated to receive the annuity benefits after the annuitant/owner’s death. Beneficiaries can be individuals, trusts, charities, etc. (Note: non-individual beneficiaries like trusts/estates have more restrictive payout options – usually 5-year rule only.)

• Death Benefit: In context of annuities, this is the amount payable to beneficiaries when the owner or annuitant dies. Some annuities guarantee a minimum death benefit (like all premiums paid, or premiums plus some interest, even if the account value is lower).

• Non-Qualified Annuity: An annuity held outside of a tax-qualified retirement plan. Funded with after-tax money. Only the earnings portion is taxable upon distribution.

• Qualified Annuity: An annuity contract within a retirement account (IRA, 401k, etc.) or otherwise funded with pre-tax dollars. Entire distribution is taxable (since none was taxed initially). Sometimes informally called an IRA annuity if in an IRA.

• Cost Basis: The amount of after-tax money invested into a non-qualified annuity. This amount is not taxed again when withdrawn. For an inherited annuity, the beneficiary inherits the decedent’s remaining cost basis. (Important: there is no step-up in basis to the date of death value; the original basis carries over.)

• Income in Respect of a Decedent (IRD): A tax term for income that the deceased had earned or was entitled to but hadn’t yet been taxed on by the time of death. Annuity gains are a prime example – they are IRD. IRD items are taxable to whoever receives them. (There is sometimes an IRD deduction available on estate tax returns or for beneficiaries if estate tax was paid on that IRD asset – a complex but relevant point for very large estates.)

• Exclusion Ratio: The fraction of each annuity payment that is considered a return of basis (and thus excluded from taxable income). Applicable when an annuity is annuitized (turned into a stream of payments). For non-qualified annuities, exclusion ratio = (basis at annuitization start) / (expected total payout). Once the basis is fully returned, payments become fully taxable.

• LIFO – Last In, First Out: The tax rule for non-annuitized withdrawals from annuities. The “last in” is interest (earnings), the “first out” of the contract when you take money. Thus, the first dollars you take from a deferred annuity are considered 100% taxable earnings until all earnings are exhausted; only then do you start getting into the basis. This contrasts with annuity payments (from annuitization) where basis and interest are spread proportionally.

• 5-Year Rule: A post-death distribution rule: the beneficiary must withdraw the entire annuity value within 5 years of the owner’s death. No specific amount each year is mandated (can be uneven), but nothing can remain by the end of the fifth year. Common default for non-qualified annuities when no stretch is chosen, and for certain non-individual beneficiaries.

• 10-Year Rule: Under the SECURE Act, for inherited retirement accounts (including IRA annuities) when the beneficiary is not eligible for lifetime stretch. All funds must be withdrawn by the end of the tenth year following the year of death. Unlike the 5-year rule, the 10-year rule applies broadly to IRAs and has that nuance of annual RMDs if decedent had begun RMDs.

• Stretch Provision (Stretch Annuity/Stretch IRA): The (now more limited) option to take inherited account withdrawals over the beneficiary’s life expectancy. For annuities, this often means taking at least annual withdrawals over your lifetime. For IRAs, this is now mostly only for eligible designated beneficiaries. “Stretch” essentially maximizes deferral.

• Spousal Continuation: The right of a surviving spouse to assume ownership of an inherited annuity (if they were named beneficiary). In non-qualified annuities, the contract continues with the spouse as the new owner, bypassing the usual 5-year rule. In qualified accounts, the spouse can roll it over to their own IRA or continue it as inherited IRA (usually rollover is chosen).

• RMD – Required Minimum Distribution: The minimum amount that must be withdrawn each year from certain retirement accounts after reaching a certain age. For inherited IRAs, RMDs can apply to beneficiaries under certain circumstances (like eligible beneficiaries stretching, or when the decedent was in pay status and the 10-year rule applies with annual minima).

• Step-Up in Basis: A step-up adjusts an asset’s cost basis to its date-of-death value, effectively wiping out taxable gain. Annuities do NOT get a step-up (except any annuity that was already annuitized might have some small basis adjustment, but generally no). This is contrasted with, say, stocks in a taxable account which typically get stepped up.

• Private Letter Ruling (PLR): Guidance issued by the IRS to an individual taxpayer on a specific situation. There have been PLRs related to inherited annuities (for example, allowing 1035 exchanges of inherited annuities). While not law for everyone, PLRs show how the IRS may interpret rules.

• 1035 Exchange: A tax-free exchange of an insurance or annuity contract for a new contract, allowed under IRC Section 1035. Normally, you can exchange your annuity for another annuity without triggering tax on gains. In the past, it was unclear if beneficiaries could do a 1035 with an inherited annuity; a 2013 PLR clarified that a beneficiary can do a 1035 exchange of an inherited non-qualified annuity into a new annuity (but they still must abide by the original distribution timeframes of 5-year or life expectancy). This can be useful if the inherited annuity is with an insurer you don’t like or has poor investment choices – you can swap to a better annuity while keeping the tax deferral.

• Estate Tax: A tax on the decedent’s estate (federal or state) based on the total value of assets at death. If applicable, the annuity’s value is included. Currently federal estate tax won’t hit unless the estate is very large (above $12 million per person, through 2025). Some states have lower thresholds.

• Inheritance Tax: A tax some states impose on the beneficiaries for receiving an inheritance. Rates can depend on the relation to decedent. Annuities inherited can be subject to this, based on the lump sum value at death, separate from income tax on the payouts.

These terms cover much of the jargon you’ll encounter. With this vocabulary in hand, let’s look at some mistakes and pitfalls to avoid when dealing with inherited annuities.

Mistakes to Avoid When Inheriting An Annuity ⚠️

Even savvy professionals can slip up on the intricacies of inherited annuities. Here are common mistakes (and how to avoid them):

• Assuming Annuities Get a Tax Basis Step-Up: Perhaps the #1 error – thinking an inherited annuity’s gains become tax-free. They don’t. Unlike stocks or real property, annuities do not receive a step-up in basis at death. If Grandpa’s $100k stock grew to $300k, heirs might sell it tax-free. If the same money was in an annuity, $200k is taxable as ordinary income to the heirs. Don’t plan with the wrong assumption – the tax man will come for annuity gains.

• Cashing Out Without a Plan: Taking a lump sum impulsively can lead to an unnecessarily large tax bill. Sometimes beneficiaries panic or just check the box for a full distribution without realizing they could spread it out. Always evaluate the other options (5-year, stretch, etc.) unless the annuity is tiny or other circumstances favor a lump sum. A knee-jerk cash-out can destroy tens of thousands in value due to taxes.

• Missing Deadlines: If you are a non-spouse beneficiary who wants the life expectancy stretch on a non-qualified annuity, you usually must start withdrawals within one year of death. If you don’t, you default to the 5-year rule and lose the chance to stretch. Similarly, for inherited IRAs under the old rules, missing the first RMD by Dec 31 of year after death would default to 5-year rule (for deaths prior to 2020). Under current rules, missing annual RMDs if required can incur a penalty (though the IRS can waive it if corrected). Mark your calendar and take action in time.

• Not Naming a Beneficiary (for original owners): This is a mistake by the original annuity owner that directly affects heirs. If no beneficiary is named, the annuity often goes to the estate by default. That typically forces a 5-year payout rule (since an estate can’t do life expectancy). It also means probate, possible loss of certain contract enhancements, and potentially higher taxes. As a beneficiary, you obviously can’t retroactively fix this, but advisors should stress to clients the importance of keeping beneficiary designations up to date. If you inherited as an estate representative, consult a tax advisor – you may have fewer options.

• Forgetting Spousal Options: If you’re a spouse and you inherit an annuity, a big mistake is not realizing you can continue it. Occasionally a surviving spouse will cash out because they think they have to, paying a bunch of tax, when they could have just rolled it over or continued the contract. Don’t let a lack of knowledge cost you. Spouses should almost never elect a 5-year or lump sum unless there’s a compelling reason – use that continuation benefit to defer tax and potentially get better long-term results.

• Trusts as Beneficiary Without Planning: If an annuity is left to a trust, the payout options can become restricted (usually to 5-year rule, unless the trust can pass-through to an individual via “look-through” rules, which is more applicable to IRAs). A common mistake is not aligning the annuity beneficiary with the trust’s provisions, causing an inadvertent acceleration of taxes. For example, if a trust was intended to provide income to a child over life, but the annuity left to it must pay out in 5 years, it forces income faster than the trust might distribute it, leading to higher trust tax (trust tax brackets are very compressed). To avoid this, either name individuals as beneficiaries or ensure the trust is set up as a see-through for retirement accounts; note that non-qualified annuities don’t have the same clear trust look-through rules as IRAs do. This is a complex area – basically, involving a trust means get professional advice to avoid tax traps.

• Ignoring Fees and Investment Choices: When you inherit an annuity, you don’t have to keep it in the same contract. If it’s a variable annuity with high fees and poor investment options, one mistake is leaving it there out of inertia. You might be able to do a 1035 exchange (for non-qualified) to a lower-cost annuity or even partial withdrawals to invest in something more suitable. Don’t assume you’re stuck with a subpar product. Just be mindful of not triggering tax – coordinate any move carefully.

• Not Considering Partial Withdrawals: Some beneficiaries think it’s all or nothing. In reality, you can do partial lump sums. For instance, take some cash now (taxable on that part) and leave some to stretch. As long as you fulfill the rules (e.g., for non-qual, the rest still must finish by 5 years if you don’t annuitize, or for IRAs, still empty by year 10), you can mix approaches. A mistake is thinking you either stretch it all or cash it all – you can blend (take a chunk for that home renovation now, stretch the rest).

• Overlooking the IRD Deduction: This is more for high-net-worth cases: If the decedent’s estate paid estate tax on the annuity (i.e., the estate was taxable and the annuity pushed it higher), the beneficiary can claim an income tax deduction for IRD (income in respect of decedent) for the portion of estate tax attributable to the annuity’s value. Many beneficiaries and even some tax preparers miss this. It’s a specialized calculation, but it can reduce the income tax on annuity payouts slightly, softening the double-tax (estate + income) hit.

• Believing Mythical “Tax-Free” Tricks: Some people search for how to avoid taxes on inherited annuities and might stumble on ideas like “transfer the annuity into a Roth IRA” or “add the beneficiary as a joint owner before death” – these generally do not work or are not permissible. Annuities inside IRAs can’t be converted to Roth by a beneficiary unless the decedent already had (and if decedent didn’t, you can’t just choose to make it Roth after). Adding a child as joint owner on a non-qualified annuity doesn’t avoid taxes either; in fact it can create gift tax issues and doesn’t change that the earnings will be taxed when withdrawn. Bottom line: be wary of anyone peddling an “annuity inheritance tax loophole.” The law is pretty tight; you can defer or spread out but not escape the taxes entirely (unless the annuity was a Roth IRA annuity – that’s different: if you inherited a Roth IRA annuity, those distributions can be tax-free if the Roth conditions are met. That’s a pro tip: Roth annuities are a thing and would be tax-free to beneficiaries after the 5-year Roth rule).

• Neglecting State Tax Considerations: As we saw, state taxes vary. A mistake is focusing only on the IRS and forgetting your state. For example, a beneficiary in Pennsylvania might not realize they owe a 4.5% inheritance tax on that annuity’s value – due pretty soon after death – which is separate from the ongoing income tax on payouts. Not budgeting for that could cause a cash crunch. Or a beneficiary in a no-income-tax state might mistakenly withhold state tax not realizing they don’t owe it. Always integrate state tax planning: check if your state taxes retirement income or has inheritance/estate taxes.

• Failure to Seek Advice: This may sound self-serving for professionals, but truly, inherited annuities can be a minefield for the uninitiated. The cost of a consultation with a CPA or financial planner is often tiny compared to a potentially avoidable tax bill. A classic mistake is a beneficiary going it alone, misunderstanding an IRS rule, and making an irreversible decision. For instance, once you elect to cash out and the check is cut, you can’t undo that tax trigger. Similarly, once a stretch is set up, you might not be able to accelerate without penalties or loss. Getting it right the first time is key – so don’t hesitate to get advice before you act.

Avoiding these mistakes will help ensure that you maximize the value of an inherited annuity and stay compliant with the various rules. Now, to tie everything together, let’s look at a couple of detailed examples and comparisons to solidify understanding.

Detailed Examples and Case Studies 📝

Let’s run through a couple more concrete examples with numbers, to illustrate how taxes on inherited annuities actually play out and how they compare to other inherited assets.

Example 1: Comparing Inherited Assets (Annuity vs. Stock vs. Life Insurance)

Imagine three siblings inherit three different assets from their grandfather, each asset worth $100,000 at his death:

• Alice inherits a non-qualified annuity with a current value of $100k (grandpa paid $60k into it originally; $40k is gain).

• Bob inherits $100k worth of stocks in a brokerage account (grandpa originally paid $60k; $40k unrealized gain at death).

• Carol inherits a $100k life insurance death benefit (grandpa paid premiums over the years, cash value wasn’t relevant; it’s a pure death benefit payout).

What are the tax consequences for each?

• Alice (Annuity): Alice has no immediate tax on simply being named beneficiary. But when she takes the money out, the $40k gain will be taxed as ordinary income. If she takes a lump sum right away, she’ll report $40,000 of additional income on her tax return. If she instead takes, say, $10k a year for 10 years, each year $4k of that $10k would be taxable (assuming an even pro-rata in that method through annuitization, roughly). Either way, eventually $40k of income gets taxed. The original $60k is tax-free return of basis.

• Bob (Stocks): The stocks get a step-up in basis. That means Bob’s basis in these shares is $100k (the value at death). If he sells them immediately for $100k, he pays zero tax – the $40k gain that existed during grandpa’s life is never taxed to anyone. Even if Bob holds the stocks for a while and they grow, any post-death growth would be taxed if realized, but any gain that was up to the date of death is essentially wiped clean. If Bob instead inherited an IRA full of stocks, that’d be different (taxable), but just inheriting a taxable account gets this beneficial treatment. So Bob could potentially pocket $100k with no income tax (or he could keep the investment).

• Carol (Life Insurance): Life insurance death benefits are generally income-tax-free to the beneficiary. Carol gets the $100k and does not have to include it in her taxable income at all. (There are rare exceptions if the policy was transferred for value or something, but assume a normal situation). So Carol’s entire $100k is tax-free. No strings attached (and life insurance isn’t part of IRD, etc., so no income tax; though if grandpa’s estate was large, life insurance could be in the estate for estate tax, but that’s beyond scope here and likely not applicable if only $100k).

So in this comparison, inheriting the annuity was clearly the least tax-favorable for the beneficiary. Both Bob and Carol can potentially use their inheritance with minimal or no tax, whereas Alice faces taxes whenever she uses hers. This example is why, from an estate planning perspective, some might prefer leaving other assets to heirs and possibly using annuities primarily for one’s own retirement (or for spouse’s benefit).

Example 2: Tax Calculation on an Inherited Annuity Withdrawal

David inherits a non-qualified fixed annuity from his aunt. It’s worth $80,000 on the date of her death. The aunt’s cost basis was $50,000 (she invested $50k, it grew to $80k). David decides to withdraw $20,000 immediately to pay off some credit card debt. How is this taxed?

Because it’s a non-qualified annuity and David is taking a withdrawal (not annuitizing), the LIFO rule applies. The annuity has $30k of gain total. The first dollars out are considered gain. So, of that $20,000 distribution:

• $20,000 will be treated as coming from the earnings portion, which is taxable as ordinary income to David.

• This will leave $10,000 of untaxed gain still in the contract.

• David will owe whatever his marginal tax rate is on that $20k. If he’s in the 24% federal bracket, that’s $4,800 federal tax, plus any state tax.

• The good news: his aunt’s $50k basis is still sitting in the contract (plus $10k of gain left). If David later takes another $20k, the first $10k of that second withdrawal will be the remaining gain (taxable), then the next $10k would dip into basis (tax-free).

If David instead had annuitized the $80k into a 10-year fixed payment stream, each payment would be part taxable. For instance, $80k over 10 years might pay about $8,000 a year (ignoring interest). Exclusion ratio = 50k/80k = 62.5% return of basis, 37.5% taxable. So each $8k payment: $5k tax-free, $3k taxable. Over 10 years he’d still pay tax on $30k total, but $3k a year might keep him in a lower bracket than a one-time $20k.

Example 3: A High Net Worth Case – Estate Tax and IRD Interaction

This one’s for the estate planners: Suppose a wealthy individual dies in 2025 with a $20 million estate, which includes a $2 million non-qualified annuity that had a cost basis of $1.2 million (so $800k of gain). They leave the annuity to their child. The federal estate tax exemption in 2025 is about $13.6M, so the estate owes estate tax on roughly $6.4M of the estate (20M – 13.6M exemption). The estate tax rate is 40%, so roughly $2.56M estate tax is due (simplified).

The $2M annuity is part of that taxable estate. Roughly 2/20 (10%) of the estate tax might be allocable to the annuity’s value (so about $256k of estate tax was effectively attributable to the annuity).

Now the child as beneficiary has to pay income tax on that $800k of gain when they withdraw from the annuity. That’s a huge taxable IRD item.

However, the tax code provides some relief: the child can claim an IRD deduction on their income tax for the estate tax paid on the IRD asset. In this case, roughly $256k estate tax was due because of including that annuity. So when the child includes distributions from the annuity in their income, they get to take an itemized deduction (usually on Schedule A) for that proportionate estate tax. If the child took the whole $800k gain in one year (extreme case), they could deduct $256k on Schedule A (not subject to 2% misc limit, it’s a special deduction), offsetting some of the tax. If they take the annuity out over time, they’d split that deduction accordingly.

This example shows that at high asset levels, inherited annuities can be taxed twice (estate and income), but at least there’s a mechanism to alleviate double taxation. For most people this won’t matter (since estate tax won’t hit), but it’s good to know for completeness.

Example 4: Partial 1035 Exchange After Inheritance

Rachel inherits a variable annuity worth $500k from her mother. It’s non-qualified, with a large gain (basis $200k, gain $300k). Rachel doesn’t want to keep that annuity because it has high fees and is with an insurance company she dislikes. But if she cashes it out, $300k becomes taxable at once – no thanks. Can she move it?

Yes, thanks to IRS guidance, she can do a 1035 exchange of an inherited annuity into a new inherited annuity contract with another insurer. She finds a low-cost annuity that allows inherited accounts. She transfers the full $500k via a direct 1035 exchange to New Insurance Co. The new annuity is now in her name as beneficiary, still labeled as an inherited non-qualified annuity. Importantly, the tax basis carries over ($200k) and the distribution timeline carries over too. If her mom died 2 years ago and Rachel was under a 5-year rule, the new contract still needs to be fully distributed by the end of 5 years from mom’s death. The exchange itself was tax-free. Now Rachel can choose to perhaps annuitize or take withdrawals from the new annuity which has better investment choices and maybe will yield more growth to help pay the taxes due on that $300k when she eventually withdraws it.

This example underlines a point: inherited annuities aren’t static – you have some planning tools like 1035 exchanges to optimize even after inheritance.

Having walked through rules, scenarios, pros/cons, and examples, let’s briefly compare inherited annuities with some similar inheritance scenarios for context.

Comparisons and Contrasts 🆚

It’s helpful to compare how inherited annuities stack up against other common inheritance situations and related financial concepts:

• Inherited Annuity vs. Inherited IRA (Traditional): Both will result in the beneficiary paying income tax on distributions. The key difference is the rules governing distributions. Inherited traditional IRAs (post-SECURE Act) mostly follow the 10-year rule (unless spouse or other eligible beneficiary), whereas non-qualified annuities follow 5-year or life. An inherited IRA doesn’t allow the option to continue growing beyond 10 years, whereas a non-qualified annuity could be stretched over life. Also, IRA distributions can be managed with some flexibility in that 10-year window (with RMD nuances), similar to annuity 5-year flexibility. Tax-wise, an IRA’s entire balance is taxable (no basis typically), while an annuity often has some basis. Verdict: In practice, they’re similar for non-spouses now (both force relatively quick payout). Spouses can roll over IRAs or continue annuities – both are great for deferral.

• Inherited Roth IRA vs. Inherited Non-Qualified Annuity: Big difference – Roth IRA distributions are generally tax-free for beneficiaries (provided the Roth was aged 5+ years). A Roth IRA is subject to the 10-year rule for non-spouse beneficiaries, but at the end of 10 years, the beneficiary can withdraw everything with zero income tax. By contrast, the non-qualified annuity might allow stretch beyond 10 years, but every distribution’s earnings are taxed. If someone’s goal is to leave tax-free income to heirs, a Roth IRA (or life insurance) beats an annuity. However, you can’t just label an annuity as Roth; the original owner would have had to use Roth IRA funds to buy it.

• Inherited Annuity vs. Life Insurance: As illustrated, life insurance death benefits are tax-free. The trade-off is that annuities are designed more for the owner’s benefit (retirement income, growth) whereas life insurance is primarily for heirs. Many clients use life insurance to pay the taxes on things like annuities or IRAs. For example, someone might have an annuity and also buy a life insurance policy so that when they die, the life insurance can provide beneficiaries cash to cover the tax on the annuity payout (this is sometimes called “wealth replacement” using life insurance).

• Inherited Annuity vs. Inherited House: If you inherit a home or other real estate, generally you get a step-up in basis to market value. If you sell the house immediately, no capital gain tax. Annuity, as we know, doesn’t step up. Also, if the house was the decedent’s primary residence, sometimes estate planning allows exclusion of gain, but mostly the step-up takes care of it. The only tax on an inherited house might be property tax ongoing, or estate tax if value high. With annuities, you always face income tax on the gain eventually.

• Inherited Stretch Annuity vs. Stretch IRA (old rules): Under old rules, both were somewhat analogous – you take out a small taxable amount each year for life. The IRA’s small RMDs vs the annuity’s partial withdrawals end up looking similar, though the annuity’s distribution might be more flexible (you could potentially withdraw more some years as needed, whereas RMD was minimum only).

• Inherited Annuity (Non-Spouse) vs. Spousal Continuation: If you compare the experience of a spousal beneficiary vs a non-spouse: The spouse essentially steps into the original owner’s shoes – no immediate tax, and can even add money or change investments. A non-spouse is more like “this is a payout to you, on a timer.” So spouses truly get a great deal. For instance, a 60-year-old spouse could keep a deferred annuity until she’s 80 before taking anything, whereas a 60-year-old child beneficiary might be forced to finish payouts by 65 at the latest (5-year rule).

• Inherited Annuity vs. Charitable Remainder Trust (CRT): This is a more exotic comparison, but sometimes people use CRTs as a way to simulate the stretch for their heirs while also benefiting charity. For example, someone could leave an annuity or IRA to a CRT at death; the CRT then pays the heir an income stream for life (similar to stretch), and whatever’s left goes to charity. The benefit is the CRT, being a trust, doesn’t pay immediate tax on receiving the IRA or annuity (it’s tax-exempt), so it can stretch out distributions to the beneficiary. The beneficiary pays tax on the income as they get it, but effectively you’ve recreated a lifetime stretch beyond the 10-year rule by using a CRT. The cost is the charity must get at least 10% of initial value by law. This is a advanced strategy that shows up in estate planning conversations for large IRAs/annuities post-SECURE Act to give heirs more drawn-out payments.

These comparisons highlight that while inherited annuities have some tax drawbacks, there are strategies and alternative tools that can be considered to achieve similar goals. Often, a comprehensive estate plan will integrate different assets (annuities, IRAs, life insurance) to balance out tax treatment for heirs.

Relevant Laws, IRS Rules, and Court Rulings 🏛️

To round out our expert discussion, it’s worth noting the key laws and even a court case or two that have shaped the landscape of inherited annuities and retirement accounts:

• Internal Revenue Code §72: This is the section of the tax code that governs annuities. Within it, IRC §72(s) specifically requires that any non-qualified annuity contract must have distribution provisions upon death of the owner – essentially the source of the 5-year or life expectancy rule. If an annuity contract didn’t enforce those rules, it would lose its tax-deferred status. So, insurance companies build those into the contracts to comply.

• Internal Revenue Code §401(a)(9) and §408: These sections cover required minimum distributions for retirement plans and IRAs. These laws (and corresponding regulations) define how inherited IRAs must be distributed. The SECURE Act amended §401(a)(9) to institute the 10-year rule for most beneficiaries. The IRS has proposed regulations (not yet final as of 2025) further detailing how the 10-year rule works with yearly RMDs in certain cases.

• SECURE Act of 2019: A pivotal law for inherited accounts. Officially, “Setting Every Community Up for Retirement Enhancement Act of 2019.” Effective for deaths after Dec 31, 2019, it eliminated the lifetime stretch for most and imposed the 10-year rule. It also raised the RMD age for owners to 72 (and later another bill, SECURE 2.0 in 2022, raised it to 73 and eventually 75 in coming years).

• IRS Publication 575 & 590-B: These IRS publications provide guidance to taxpayers. Pub 575 covers annuities and pensions (including how to calculate taxable part of annuity payments, etc.). Pub 590-B covers distributions from IRAs, including inherited IRA rules. They are useful references for technical details on these topics straight from the IRS.

• Private Letter Ruling 201330016 (2013): In this PLR, the IRS allowed beneficiaries of inherited annuities to do a 1035 exchange into new annuities without triggering taxes, as long as the required distribution period wasn’t extended. This was a game-changer, confirming that beneficiaries aren’t locked into the original annuity contract.

• Private Letter Rulings 2020- and 2021-: There have been a few PLRs in 2020 and 2021 where the IRS allowed things like reforming a trust to allow stretch or fixing a missed RMD by post-mortem actions. While PLRs can’t be cited as precedent by others, they reveal IRS thinking. By and large, the IRS has been strict on the new 10-year rule (initially causing confusion by implying annual RMDs in the 10-year window if decedent had RMDs – which they later confirmed is indeed their stance).

• Clark v. Rameker, 573 U.S. 122 (2014): A U.S. Supreme Court case relevant to inherited IRAs. The Court ruled that inherited IRAs are not “retirement funds” protected in bankruptcy. In other words, if you inherit an IRA and then declare bankruptcy, creditors can go after that inherited IRA (unlike your own IRA which is usually shielded up to a high amount). While not a tax case, it’s important for financial planning: it underscores that inherited accounts are fundamentally different from your own retirement funds. This case might encourage some people to leave inherited IRAs to trusts for creditor protection, etc.

• Estate of Kurihara v. Commissioner (T.C. Memo 2013-230): A tax court case involving an inherited annuity. The details are complex, but one takeaway was that the taxpayer tried to argue for a step-up in basis for the annuity or that it wasn’t IRD. The court disagreed – confirming that deferred annuity gains are IRD and taxable to the beneficiary. It’s a reminder that the courts have consistently upheld the tax treatment as the IRS applies it: no step-up for annuity gains.

• Potential Upcoming Changes: Tax laws evolve. The current high estate tax exemption is set to drop in 2026 (back to ~$5-6 million, adjusted) unless extended. If that happens, more estates (and the annuities in them) could be subject to estate tax, making the IRD deduction more relevant. Also, there have been proposals in past to eliminate stretch entirely (like make even spouses withdraw faster) or conversely, to bring back some stretch options – it’s always in flux. Professionals should keep an eye on new legislation (e.g., a hypothetical “SECURE Act 3.0”). Additionally, states sometimes update inheritance tax laws (like Iowa phasing out theirs, etc.).

By understanding these laws and rulings, you can appreciate why the rules are the way they are. The bottom line from a policy perspective is: Congress wants their tax revenue from tax-deferred accounts not too long after the original owner’s death, with some leniency for spouses and special cases. Courts have mostly supported that policy. And states have their own say with estate/inheritance taxes.

Wrapping up: Inherited annuities are a complex intersection of insurance, tax, and estate law. We’ve covered the immediate answer – yes, they are taxable – and dug deep into the nuances that financial advisors, estate attorneys, CPAs, and informed consumers need to know.

For a quick final recap in Q&A form, let’s address some frequently asked questions about inherited annuities:

FAQ 🙋

Q: Are inherited annuity payments taxed as ordinary income?
A: Yes. Inherited annuity distributions are taxed as ordinary income to the beneficiary, not as capital gains. They’re treated like the original owner’s deferred income.

Q: Does an inherited annuity get a step-up in cost basis at death?
A: No. Annuities do not receive a step-up in basis. The beneficiary inherits the annuity’s existing cost basis, so any untaxed gains remain taxable to the beneficiary.

Q: Can I avoid paying taxes on an inherited annuity?
A: No, you generally cannot avoid the taxes. You can only defer or spread out the tax by choosing certain payout options. Eventually, any untaxed earnings will be taxed when withdrawn.

Q: Do I have to pay the 10% early withdrawal penalty on an inherited annuity?
A: No. Inherited annuity (and inherited IRA) distributions are exempt from the 10% early withdrawal penalty, regardless of the beneficiary’s age.

Q: If I inherit an annuity, will it be subject to estate tax?
A: Maybe. The annuity’s value is included in the decedent’s estate. Federal estate tax applies only if the total estate exceeds the exemption (~$12.92M in 2023). Some states have estate taxes with lower thresholds.

Q: Which states charge an inheritance tax on annuities?
A: States like Pennsylvania, New Jersey, Kentucky, Maryland, Nebraska, and Iowa (until phased out) have inheritance taxes. A spouse beneficiary is usually exempt, but other beneficiaries in those states may owe a percentage of the annuity’s value.

Q: Is a spouse’s inherited annuity taxable immediately?
A: No. A spouse can continue a non-qualified annuity or roll over a qualified annuity, deferring taxes. When the spouse eventually takes distributions, then it’s taxable. There’s no tax at the moment of inheritance for a spouse.

Q: What is the five-year rule for inherited annuities?
A: It requires a non-spouse beneficiary to withdraw the entire annuity by December 31 of the fifth year after the owner’s death. The beneficiary can choose how much to take out each year (no set amount, as long as all is out by the deadline).

Q: Can I stretch an inherited annuity over my lifetime?
A: If it’s a non-qualified annuity and the contract allows, yes – you can take withdrawals over your life expectancy (often by annuitizing). If it’s an IRA annuity, only if you’re an eligible designated beneficiary (otherwise you’re limited to 10 years).

Q: Are inherited annuity lump sums taxed differently than periodic payments?
A: No difference in rate – both are ordinary income. The difference is timing. A lump sum taxes all gain in one year, whereas periodic payments spread the taxable income over years.

Q: If an annuity was annuitized before death, how are payments to the beneficiary taxed?
A: If the original owner had annuitized and was receiving payments, and a beneficiary continues to receive the remaining guaranteed payments, the same exclusion ratio applies. The portion of each payment that was taxable to the owner remains taxable to the beneficiary.

Q: Can an inherited annuity be rolled into an IRA or another tax-deferred account?
A: A non-qualified annuity cannot be rolled into an IRA. An inherited IRA annuity can be transferred to an inherited IRA (staying tax-deferred) but not merged into the beneficiary’s own IRA (unless spouse). Non-qualified annuities can be exchanged to another annuity via 1035 exchange but not to IRAs.