Is an Inherited Annuity Taxable?

Yes, an inherited annuity is usually taxable, but how much of it is taxed depends on what kind of money funded it. With a non-qualified annuity (bought with after-tax savings), beneficiaries pay ordinary income tax only on the gains. With a qualified annuity (inside an IRA or other retirement plan), the whole amount is generally taxable as it comes out.

The other big lever is timing. Beneficiaries often get to choose how fast they take the money, and that choice can matter as much as the tax rate itself.

Do beneficiaries pay taxes on an inherited annuity?

Yes. Beneficiaries owe ordinary income tax on any portion of an inherited annuity that was never taxed before, and they owe it in the year they receive it. Annuity growth is tax-deferred, not tax-free, so taxes the original owner never paid pass along to whoever inherits the contract.

The IRS treats that untaxed growth as "income in respect of a decedent" under IRC Section 691. In plain English, it's income the owner earned but never reported, so it gets reported by the heir instead. It is taxed at ordinary income rates, not the lower capital gains rates, no matter how long the contract was held.

One piece of good news: the 10% early-withdrawal penalty does not apply. Distributions made because of the owner's death are exempt under IRC Section 72(q) for non-qualified contracts and Section 72(t) for retirement accounts, regardless of the beneficiary's age.

How is a non-qualified inherited annuity taxed?

Only the gain is taxable. The original owner's cost basis (the after-tax money they paid in) comes back to the beneficiary tax-free. If the owner paid $100,000 into a contract that is worth $140,000 at death, the beneficiary owes income tax on $40,000, not $140,000.

How that gain is taxed depends on how it is taken:

• Lump sum: the entire gain is taxable in the year paid, which can push a beneficiary into a higher bracket.
• Withdrawals under the five-year rule: gains generally come out first and are taxed as withdrawn, and the basis comes out last.
• Annuitized or life-expectancy payments: each payment is split by an exclusion ratio into a tax-free return of basis and a taxable gain, spreading the tax over many years.

The distribution deadlines for non-qualified annuities come from IRC Section 72(s): the beneficiary generally has to either empty the contract within five years of the owner's death, or begin payments over their life expectancy within one year of the death. The options themselves are covered in what happens to an annuity when you die.

How is a qualified (IRA) annuity taxed when inherited?

When the annuity sits inside an IRA, 401(k), or similar plan, every dollar was usually pre-tax, so the entire distribution is taxable as ordinary income. The exception is a Roth IRA annuity, where qualified distributions are generally tax-free, provided the Roth's five-year holding requirement has been met.

Qualified annuities follow the retirement account rules rather than Section 72(s). Since the SECURE Act took effect in 2020, most non-spouse beneficiaries who inherit a retirement account must empty it by the end of the tenth year after the owner's death. That replaced the old lifetime "stretch" for most heirs. A group called eligible designated beneficiaries can still use life-expectancy payments: a surviving spouse, the owner's minor child (until reaching majority), a disabled or chronically ill beneficiary, and someone not more than ten years younger than the owner.

If the owner had already begun required minimum distributions, IRS regulations finalized in 2024 generally require the beneficiary to keep taking annual distributions during the ten-year window, not just empty the account at the end. These rules have shifted several times since 2020, so it's worth confirming the current guidance in IRS Publication 590-B before deciding.

How do the rules for non-qualified and qualified inherited annuities compare?

The biggest differences are what's taxable and how long a non-spouse beneficiary has to withdraw the money.

Do inherited annuities get a step-up in basis?

No. Annuities do not receive a step-up in basis at death, which is the biggest tax difference between inheriting an annuity and inheriting stocks, funds, or real estate. When someone inherits a brokerage account, its cost basis is generally reset to the value on the date of death, wiping out the built-in gain. An annuity's untaxed growth carries over to the heir intact.

This is one reason annuities are usually a better fit for money the owner plans to use during their lifetime than for money meant purely for heirs. If leaving a tax-efficient inheritance is the main goal, compare the options in annuity vs. life insurance, since life insurance death benefits are generally received income tax-free.

There is one partial offset. If the estate was large enough to owe federal estate tax, the beneficiary may be able to claim an income tax deduction for the estate tax attributable to the annuity under IRC Section 691(c). This applies to relatively few estates, but it's worth asking a tax professional about if yours is one.

What happens if a spouse inherits the annuity?

A surviving spouse usually has the most favorable option: continuing the contract as the new owner, which keeps the tax deferral going and triggers no tax at the time of death. Taxes are owed only when the spouse later takes withdrawals, under the same rules that applied to the original owner.

For an IRA annuity, the spouse can typically treat the account as their own IRA or roll it into one. That can delay required distributions until the spouse reaches their own required beginning age. A spouse who is younger than 59½ and needs income may instead prefer to keep it as an inherited account, since distributions from an inherited account avoid the 10% penalty. The choice is often one-way, so it's worth thinking through before signing the claim forms.

How can a beneficiary reduce the tax hit?

The main tool is spreading distributions across several tax years instead of taking a lump sum. Because inherited annuity gains are ordinary income, a large one-year payout can stack on top of a beneficiary's salary and land in a higher bracket.

• Use the full window. Under the five-year or ten-year rule, taking roughly equal amounts each year (or bunching withdrawals into lower-income years) usually beats one large payment.
• Consider life-expectancy payments where they're allowed, which spread the tax over decades.
• Watch the deadline to elect. Missing the window to choose a payout option can force a beneficiary into a faster schedule.
• Remember state tax. Most states tax this income too, and a handful of states have separate inheritance taxes.

None of this is tax advice for your situation. A tax professional can model the tradeoff between paying sooner at a lower total and paying later across more years.

What can annuity owners do now to help their heirs?

Owners can make the biggest difference with beneficiary designations and payout choices made long before death. Name beneficiaries (and contingents) directly rather than leaving the contract to your estate, which can collapse the options to the five-year rule. Think about whether a payout option with a refund or period-certain feature makes sense if you want something left for heirs. And if you hold large unrealized gains in an annuity, our annuity taxes guide and the Roth conversions explainer cover planning moves that can reduce what heirs eventually owe.

Annuities still do the job they're built for, principal protection and guaranteed income during your lifetime, well. They're simply not the most tax-efficient way to pass money on. You can compare contracts with our free tools, or talk to a licensed advisor on a call about how a specific contract's death benefit would be paid and taxed.

Sources

• Internal Revenue Code Section 72(s) (required distributions where the holder dies)
• Internal Revenue Code Section 72(q) and 72(t) (additional tax on early distributions and exceptions)
• Internal Revenue Code Section 691 (income in respect of a decedent)
• SECURE Act of 2019 and IRS final regulations on required minimum distributions (2024)
• IRS Publication 575, Pension and Annuity Income
• IRS Publication 590-B, Distributions from Individual Retirement Arrangements