Inherited Annuity Taxes: Rules for Spouses and Non-Spouse Beneficiaries

When you inherit an annuity, the tax bill depends on two questions: what kind of money is inside the contract, and who you are to the person who died. A surviving spouse inheriting a non-qualified annuity has options a niece inheriting an IRA annuity simply doesn't. This guide sorts the rules by those two questions.

One scope note: this article covers the tax side. For the contract mechanics — how death benefits work, owner-driven versus annuitant-driven contracts, and what beneficiaries actually receive — start with what happens to an annuity when you die.

The Ground Rules: No Step-Up, Ordinary Income, Gains Only

Three facts frame everything that follows:

• There is no step-up in basis. Inherited stocks shed their built-in gains at death; inherited annuities don't. The deferred gain is "income in respect of a decedent," and the income tax bill transfers to the beneficiary along with the money.
• Gains are ordinary income. Annuity earnings never qualify for capital-gains rates — not to the owner, and not to you.
• Only the gain is taxable (in a non-qualified contract). The owner's after-tax premium comes back to you tax-free as basis; the growth above it is what the IRS taxes.

One piece of good news: the 10% additional federal tax on withdrawals before age 59½ does not apply to death-benefit distributions. Beneficiaries of any age owe income tax on the gains, but not the early-withdrawal penalty.

Non-Qualified Annuities: Your Distribution Options

A non-qualified annuity was bought with after-tax money outside any retirement plan — the product our non-qualified annuity guide covers. Federal law requires beneficiaries of a deferred contract to take the money out on one of a few schedules, and the choice controls how fast the tax comes due:

Lump Sum

You take everything at once, and the entire gain lands on that year's tax return as ordinary income. Simple, but it can stack a decade of deferred growth into a single year and push you into higher brackets. Usually the worst tax outcome for a contract with large gains.

The 5-Year Rule

You can leave the money in the contract, still growing tax-deferred, so long as it's fully distributed within five years of the owner's death. There's no required pattern inside the window — you might take a slice each year to smooth the brackets, or wait and take it all in a low-income year. Flexibility is the appeal; the deadline is the constraint.

The Nonqualified Stretch (Life-Expectancy Payments)

If you begin payments within one year of the owner's death, you can instead take distributions over your own life expectancy — annuitizing the death benefit or taking life-expectancy withdrawals, depending on what the carrier offers. Each payment is part taxable gain and part tax-free return of basis, and the untouched balance keeps compounding tax-deferred. For a younger beneficiary of a high-gain contract, the stretch usually produces the smallest lifetime tax bill. The taxable-slice math works like the exclusion ratio on any annuitized contract.

Two cautions: the one-year clock is unforgiving — miss it and you're back to the 5-year rule or a lump sum — and not every carrier offers a stretch option, so ask before assuming.

The Spouse Exception: Continuation

A surviving spouse who is the sole primary beneficiary generally has a fourth option none of the schedules above require: continue the contract as if they had owned it all along. Tax deferral keeps running, no distributions are forced, and the spouse names new beneficiaries. Nothing is taxable until the spouse actually withdraws.

The trade-off hides in the penalty rules. Once a spouse continues the contract, it's treated as their own — so withdrawals the spouse takes before their own age 59½ can owe the 10% additional tax that a death-benefit distribution would have avoided. A younger surviving spouse who expects to need the money soon should run both paths before electing continuation.

Qualified Annuities: Different Rulebook Entirely

If the annuity lived inside a traditional IRA or employer plan — a qualified annuity — the retirement-account rules override everything above. Distributions are generally fully taxable as ordinary income, because the contributions were pre-tax. And since the SECURE Act took effect for deaths after 2019, most non-spouse beneficiaries must empty the inherited account within 10 years.

• Surviving spouses keep the most room: roll the money into their own IRA, or treat it as an inherited IRA with distributions over life expectancy.
• Most other beneficiaries fall under the 10-year rule — the account must be empty by the end of the tenth year after death, with annual required distributions in some cases depending on whether the owner had already started RMDs.
• Eligible designated beneficiaries — the disabled or chronically ill, beneficiaries not more than 10 years younger than the owner, and the owner's minor children until adulthood — can still stretch over life expectancy.
• Roth accounts follow the same timelines, but qualified distributions come out tax-free — which argues for letting an inherited Roth grow the full 10 years.

The beneficiary-timing rules interact with the owner's own required minimum distributions in ways that changed under the SECURE Act and its follow-up regulations — this is the corner of the map where a tax professional earns their fee.

If the Annuity Was Already Paying Income

Everything above assumes a deferred contract still in accumulation. If the owner had already annuitized — or owned an immediate annuity — there's no account balance to elect over. What you receive is whatever the payout option promised: nothing under a life-only contract, the remaining guaranteed payments under a period-certain option, the unreturned premium under a cash refund annuity, or continued lifetime payments under a joint and survivor annuity.

Continued payments keep the decedent's tax treatment: the same exclusion ratio splits each check into taxable gain and tax-free return of basis until the basis is used up, after which payments are fully taxable.

Estate Tax and the IRD Deduction

The annuity's date-of-death value is part of the owner's estate for estate-tax purposes. Most estates owe no federal estate tax, but when one does, beneficiaries get a partial offset: an itemized income-tax deduction for the estate tax attributable to the annuity's deferred gain (the income-in-respect-of-a-decedent deduction). It's obscure and routinely missed — if the estate paid federal estate tax, raise it with your tax preparer.

Next Steps for Beneficiaries

Before electing anything, get the carrier's death-claim packet and confirm three numbers in writing: the death benefit value, the decedent's cost basis, and which distribution options this contract actually offers. Then match the schedule to your bracket — spreading gains beats stacking them. The broader framework lives in our guide to annuity taxation, and if you plan to move inherited money into a contract of your own someday, understand how 1035 exchanges work and compare today's best annuity rates before committing.