Inheriting an Annuity: Tax Rules and What to Do Next

Inherited annuities are one of the most tax-complex inheritances you can receive — and one of the most misunderstood. Unlike inherited stocks, there's no step-up in basis. Unlike inherited IRAs, there's no hard 10-year deadline. The rules depend on whether it's a qualified or non-qualified annuity, who you are to the decedent, and what the insurance company allows.

Qualified vs. non-qualified annuity — which rules apply to you?

The first step is identifying what kind of annuity you inherited. The answer determines which rules govern your distributions.

Non-qualified annuity (most standalone contracts)

A non-qualified annuity is held outside a retirement account. The original owner funded it with after-tax dollars. If you're looking at an annuity contract from an insurance company that isn't labeled as an IRA, 401(k), or other qualified plan, it's almost certainly non-qualified. These contracts follow IRC §72(s) distribution rules, covered in detail below.

Qualified annuity (inside an IRA or 401(k))

If the annuity was held inside a traditional IRA or 401(k) — a common structure for fixed or variable annuities purchased within a retirement account — it follows inherited IRA rules: the 10-year distribution rule under SECURE Act (IRC §401(a)(9)(H)), potential annual RMDs under T.D. 10001 if the owner died after their Required Beginning Date, and ordinary income tax on every dollar distributed. See our Inherited IRA 10-Year Rule guide for those rules.

This guide focuses on non-qualified annuities — the §72(s) scenario.

Why inherited annuities get no step-up in basis

When you inherit stocks or real estate, your cost basis "steps up" to the fair market value on the date of death, eliminating embedded gains (IRC §1014). Annuities don't qualify for this treatment. The IRS considers annuity gains to be "income in respect of a decedent" (IRD) — income the decedent earned but didn't yet pay tax on. That tax liability passes to you as the beneficiary.

The practical impact: if the original owner paid $200,000 in premiums and the contract grew to $380,000, you've inherited $180,000 of embedded gain that will eventually be taxed at ordinary income rates as you take distributions. No step-up, no LTCG rate — ordinary income, full stop.

How annuity gains are taxed: the LIFO rule

Non-qualified annuity withdrawals follow a last-in, first-out (LIFO) rule under IRC §72(e). Gains are deemed distributed first, before any of the original principal (cost basis) comes back to you.

Example: You inherit a non-qualified annuity with $200K of premiums paid (cost basis) and $380K of current value ($180K of gain). If you take a $100K lump sum distribution, all $100K is taxable as ordinary income — because the $180K of gain comes out first. Only after you've withdrawn all $180K of gain would subsequent distributions be tax-free return of basis.

This differs from how annuitized payments work (see Exclusion Ratio below) — the LIFO rule applies specifically to partial withdrawals and lump sum distributions from a non-annuitized contract.

Your distribution options under IRC §72(s)

As a non-spouse beneficiary, IRC §72(s)(1) requires that the entire contract be distributed, but gives you meaningful choices about how:

Option 1: Lump sum

Take the full contract value immediately. The gain portion is taxed as ordinary income in the year you receive it. Fastest, most straightforward, and potentially most tax-expensive if the gain is large relative to your current bracket.

When it makes sense: You're in a low-income year (retired, between jobs), the gain is modest, or the surrender charges have already expired.

Option 2: 5-year rule

You must fully distribute the contract within 5 years of the owner's death, but you can spread the withdrawals however you choose within that window. There's no annual distribution requirement — you could take nothing for 4 years and then clean out the contract in year 5, or spread it evenly.

When it makes sense: You expect lower income in a specific future year (planned retirement, end of a high-earning period) but need the contract cleared within 5 years for other reasons.

Option 3: Life expectancy stretch — the most tax-efficient option many people don't use

Under IRC §72(s)(2)(B), if you begin distributions within one year of the annuity owner's death, you can spread them over your life expectancy. Unlike inherited IRAs (where SECURE Act capped most non-spouse beneficiaries at 10 years), non-qualified annuities still allow a true lifetime stretch. This is one of the few areas where non-qualified annuities have a structural advantage over inherited retirement accounts.

Tax impact: By spreading distributions over, say, 25 years, you can keep each annual distribution small enough to stay in lower tax brackets. A $180K gain distributed over 25 years is $7,200/year of ordinary income — a very different tax picture than $180K hitting in a single year.

Deadline warning: The window to elect the life expectancy option closes one year after the owner's death. Miss it and you're limited to the 5-year rule. This is one reason to act quickly after inheriting an annuity.

Option 4: Annuitize the contract

Convert the contract to an income stream — monthly or annual payments over a defined period or your lifetime. Each payment has two components: taxable gain and tax-free return of basis, calculated using an exclusion ratio (your cost basis ÷ the expected total payments). Once the basis has been fully returned, subsequent payments are fully taxable.

When it makes sense: You want guaranteed income and don't need a lump sum. Annuitization also "locks in" the exclusion ratio, which can be favorable if the contract value has dropped.

Spousal continuation — the unique option for surviving spouses

Under IRC §72(s)(3), if you are the surviving spouse and the sole beneficiary, you have an option no other beneficiary gets: you can elect to be treated as the new contract owner and continue the annuity as if it were your own. No distribution required. The contract simply continues with your name on it, and you defer distributions under the original terms.

This mirrors the spousal rollover option for inherited IRAs and is a significant benefit — you keep the tax deferral running and avoid immediate income recognition. When you later take distributions, the same LIFO/exclusion ratio rules apply, but you've gained potentially decades of additional tax-deferred growth.

The exclusion ratio for annuitized payments

When you annuitize a non-qualified contract (convert it to a stream of guaranteed payments), each payment is partly taxable and partly tax-free. The formula:

Exclusion ratio = Cost basis ÷ Expected total payments
Tax-free portion per payment = Payment amount × Exclusion ratio
Taxable portion per payment = Payment amount × (1 − Exclusion ratio)

Example: You inherit a contract with $200K of basis. You annuitize it for $2,000/month over a 20-year period certain ($480,000 expected total payments). Exclusion ratio = $200,000 ÷ $480,000 = 41.7%. Each $2,000 payment: $833 tax-free (return of basis), $1,167 taxable (ordinary income). Once the $200K basis has been fully recovered — roughly after 100 months — all remaining payments are fully taxable.

No 10% early withdrawal penalty

The 10% penalty under IRC §72(q) that applies to premature withdrawals from a non-qualified annuity (before age 59½) does not apply to inherited contracts. As a beneficiary, you can take distributions at any age without penalty, regardless of your age or the owner's age at death. You'll still owe ordinary income tax on the gain portion — but the 10% surcharge is gone.

Surrender charges: the practical obstacle

Even when the tax math favors a quick lump sum, surrender charges can make it expensive. Most annuity contracts have a surrender period (often 5–10 years from purchase) with declining surrender charges — a typical schedule might be 7%, 6%, 5%, 4%, 3%, 2%, 1%, 0%. If the original owner bought the contract 3 years ago, you may be facing a 5% exit fee on the contract value.

Before deciding anything, get the surrender charge schedule from the insurance company. A $400K contract with a 5% surrender charge costs $20,000 to exit immediately. The stretch option avoids surrender charges by keeping the contract in force through free withdrawal amounts (most contracts allow 10% free withdrawal per year without charge).

Ordinary income tax on annuity gains — 2026 brackets

Annuity distributions add to your ordinary income. Where they land in the brackets determines the marginal tax cost:

Source: IRS Rev. Proc. 2025-32. OBBBA (July 2025) permanently extended the TCJA ordinary income rate structure with inflation adjustments. Standard deduction 2026: $16,100 (single) / $32,200 (MFJ).

The annuity gain — taxed as ordinary income — stacks on top of your other income. If you have $80,000 of salary and you take a $100,000 annuity distribution with $70,000 of gain, that $70,000 sits mostly in the 22%–24% brackets. Spread the same gain over 15 years at ~$4,700/year and it may land entirely at 12%.

Decision framework: lump sum vs. stretch vs. annuitize

Inherited annuity inside an estate — probate and titling

If you're named as a named beneficiary on the contract, the annuity passes directly to you outside of probate — just like life insurance. You'll need to file a claim with the insurance company and provide a certified death certificate. The insurer will walk you through the election form for your distribution option.

If the annuity names the estate as beneficiary (or the owner died without naming one), the contract becomes part of the probate estate. In that case, the estate — as a non-natural person — is limited to the 5-year rule only; the life expectancy stretch is not available to estates or most trusts.⁴ This is a significant planning disadvantage. It's one reason advisors typically recommend naming a living person as beneficiary on annuity contracts, not the estate.

Common scenarios

Scenario 1: $300K contract, $110K of gain, you're 58 and still working

Your other income: $95,000. A $300K lump sum would dump $110K of gain on top of $95K — pushing your total to $205K, with the incremental gain taxed at 22%–24%. Instead, elect the life expectancy stretch (you're 58 with ~27 years per IRS tables). Annual distributions of roughly $11K keep the gain well within the 22% bracket alongside your salary. Over your working years, the annual bite is manageable. Once you retire and income drops, larger distributions at lower rates can clear the contract faster.

Scenario 2: $180K contract, $35K of gain, surrender period expired, you're 65 and just retired

Your income in retirement: $28,000. A $35K gain distribution brings your total to $63K — partly at 12%, partly at 22%. Taking the full lump sum this year (your first year of lower retirement income) may be the cleanest move: the gain is modest, brackets are favorable, and you simplify your estate by eliminating the contract.

Scenario 3: Surviving spouse, $700K contract, $280K of gain

Elect spousal continuation. You're now the contract owner. The $280K of gain continues to compound tax-deferred. You can take distributions strategically in lower-income years, use the 10%/year free withdrawal feature, or eventually annuitize for lifetime income. No immediate tax event.

Sources

1. IRC § 72 — Annuities; Certain Proceeds of Endowment and Life Insurance Contracts (LII / Cornell Law). Subsection (s) governs distribution requirements after holder's death; subsection (e) establishes the gain-first (LIFO) rule; subsection (b) provides the exclusion ratio for annuitized payments.
2. IRS Publication 575 (2025) — Pension and Annuity Income. Covers taxable/nontaxable amounts, exclusion ratio computation, and treatment of distributions from non-qualified annuities.
3. IRS Rev. Proc. 2025-32 — 2026 inflation-adjusted tax parameters. Ordinary income brackets and standard deduction amounts cited in this guide.
4. IRC § 72(s) — Required Distributions Where Holder Dies Before Entire Interest Is Distributed. Life expectancy stretch (§72(s)(2)(B)) requires a "designated beneficiary" — estates and most trusts do not qualify and are limited to the 5-year rule under §72(s)(1)(B).
5. IRS Rev. Rul. 2002-62 — Distribution Rules for Non-Qualified Annuities After Owner's Death. Provides guidance on the one-year window for electing the life expectancy option under §72(s).

Values verified April 2026. Non-qualified annuity taxation and distribution rules are complex and vary by contract terms, insurance company policies, and individual circumstances. The surrender charge schedule and free-withdrawal provisions of your specific contract materially affect the optimal decision — verify with the insurer before making any election. Consider consulting an inheritance specialist before distributing a large annuity.