Inherited Annuity Taxes: What Beneficiaries Owe and the Options That Change It

Most inherited property gets a step-up in basis: the heir's cost becomes the value on the date of death, and the gain that built up during the owner's life is never taxed. Annuities do not get that treatment. The growth inside an annuity is income the owner deferred but never paid tax on, and the tax code treats it as income in respect of a decedent. Whoever receives it pays ordinary income tax on it, exactly as the owner would have.

The premium the owner paid with after-tax money (the investment in the contract) is still recovered tax-free by the beneficiary. So an inherited non-qualified annuity worth $150,000 that was bought for $100,000 carries $50,000 of taxable income and $100,000 of tax-free basis. The insurer usually tracks this figure; if it does not, the beneficiary needs the original owner's records.

If the annuity was inside a traditional IRA or employer plan, none of the money was taxed going in, so the entire value is taxable income to the beneficiary as it is withdrawn. A Roth IRA annuity is the mirror image: qualified withdrawals by the beneficiary are tax-free, though the account must still be emptied on the schedule the law sets.

Takeaway: The tax the original owner deferred does not disappear at death. It transfers to the beneficiary, spread over whatever payout schedule the beneficiary chooses or the law requires.

A spouse named as sole beneficiary of a non-qualified annuity can elect spousal continuation: the spouse becomes the owner, the contract stays in force, and no tax is due until the spouse withdraws money. Deferral continues on the same terms, the surrender schedule is usually waived or restarted depending on the contract, and any death benefit guarantee typically resets to the current value. This is the most tax-efficient choice for most surviving spouses who do not need the money immediately.

The spouse can instead take the death benefit as a lump sum or under the same five-year or life-expectancy options available to any beneficiary. For an annuity inside the deceased spouse's IRA, the surviving spouse has the broadest choices of anyone: roll it into their own IRA, treat the account as their own, or remain a beneficiary and take distributions on their own life expectancy. Which is best depends on the survivor's age relative to 59 and a half and on when they will need the money.

Federal law requires a non-spouse beneficiary of a non-qualified annuity to receive the full value within five years of the owner's death, or to begin payments over the beneficiary's life expectancy within one year of death. Within those limits the contract decides what it actually offers. Three shapes are common.

A lump sum pays everything at once. It is simple, and it puts the entire gain into one tax year, which for a large contract can push a beneficiary into a higher bracket and affect other income-based items. The five-year rule leaves the money in the contract, still growing tax-deferred, and lets the beneficiary withdraw in any pattern as long as the account is empty within five years of the owner's death. Spreading withdrawals across several tax years often reduces the total tax paid. The life-expectancy or nonqualified stretch option, offered by many but not all insurers, pays annual amounts calculated over the beneficiary's remaining life expectancy, keeping most of the money deferred for decades; it must be elected within one year of death, and payments must begin on time.

A beneficiary who does nothing by the deadline is usually defaulted to the five-year rule by the contract. Trusts and estates named as beneficiary generally lose the life-expectancy option and are limited to a lump sum or five years, because they have no life expectancy of their own.

An annuity inside a traditional IRA is an IRA asset, so the inherited IRA rules govern it. For owners who died after 2019, the SECURE Act requires most non-spouse beneficiaries to withdraw the entire account by the end of the tenth year after the year of death. Every dollar withdrawn is ordinary income, since nothing was taxed going in. If the owner had already reached the age at which required minimum distributions begin, the beneficiary must also continue taking annual minimum distributions during years one through nine, under IRS regulations issued in 2024.

Eligible designated beneficiaries keep the older life-expectancy stretch: a surviving spouse, the owner's minor children until they reach the age of majority (after which the 10-year clock starts), disabled or chronically ill individuals, and anyone not more than 10 years younger than the owner. Beneficiaries who are not individuals, such as an estate or a non-qualifying trust, fall under a five-year rule if the owner died before the required beginning date, or must continue the owner's remaining life-expectancy schedule if the owner died after it.

A subtlety for annuitized IRA contracts: if the owner had already turned the annuity into a stream of payments that meets IRS rules, the beneficiary generally continues receiving the remaining guaranteed payments on that schedule, and those payments count toward the distribution requirements. The insurer and the IRA custodian should be able to confirm which regime applies before the first payment is taken.

Takeaway: For an IRA annuity, the 10-year rule usually controls. The contract's own beneficiary options cannot extend a deadline the tax code sets.

If the owner died while the contract was still deferred, the beneficiary receives the death benefit, usually the greater of the account value and the total premiums less withdrawals, sometimes a stepped-up value if an enhanced death benefit rider was bought. Surrender charges are waived. The beneficiary then chooses among the options above.

If the owner had already annuitized, what the beneficiary receives depends on the payout option the owner chose. Life-only payments stop at death and nothing passes to anyone. Life with a period certain continues the remaining guaranteed payments (for example, the balance of a 20-year certain period) to the beneficiary, each one taxed under the same exclusion ratio the owner used; some contracts allow those remaining payments to be commuted to a lump sum. Joint and survivor payments continue for the survivor's life. There is no separate death benefit on an annuitized contract beyond what the payout option provides.

The value of an annuity at death is included in the owner's gross estate for federal estate tax purposes, whether it passes by beneficiary designation or through a will. The federal estate tax exemption is high and indexed for inflation each year, so the great majority of estates owe no federal estate tax; the IRS publishes the current threshold. A minority of states levy their own estate or inheritance tax with lower thresholds, and a beneficiary in one of those states should check whether the annuity is subject to it.

When an estate does owe federal estate tax on an annuity, the beneficiary who later pays income tax on the same earnings can claim an itemized deduction for the estate tax attributable to that income, so the money is not fully taxed twice. This deduction for income in respect of a decedent is easy to miss and worth raising with a tax preparer whenever a taxable estate includes an annuity.

Each year a beneficiary receives money, the insurer issues Form 1099-R showing the gross amount, the taxable amount when the company can determine it, any federal withholding, and a distribution code that identifies the payment as a death benefit, which tells the IRS the 10% additional tax for early withdrawals does not apply. Death-benefit payments are exempt from that additional tax regardless of the beneficiary's age. Withholding on a lump sum is a prepayment, not the final tax; a large death benefit can produce a balance due at filing.

The steps below apply to nearly every inherited annuity. The deadlines are the ones that cause the most expensive mistakes, so they come first.

• Notify the insurer and request the beneficiary claim forms; ask for the date-of-death value and the investment in the contract.
• Note the deadlines: one year from death to elect life-expectancy payments if offered, five years to empty a non-qualified contract, ten years for most inherited IRA annuities.
• Ask which options the contract actually offers a beneficiary in your category (spouse, individual, trust, estate).
• Estimate the tax under each option across the years involved, not just the first year, before choosing.
• Make the federal withholding election deliberately and check for state withholding rules.
• Keep the 1099-R and the basis records; if the taxable amount is not shown, you will need the original owner's premium history.
• If the estate was large enough to owe federal estate tax, ask a preparer about the deduction for estate tax paid on income in respect of a decedent.