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Inheriting an annuity can provide valuable financial support, but it can also create unexpected tax obligations if you don’t understand the rules. Unlike many inherited assets that receive a step-up in basis, annuities are often taxable when distributed, sometimes leading to higher income taxes for beneficiaries. The good news is that with careful planning and a clear understanding of your payout options, you can minimize the tax impact and keep more of the annuity’s value.
If you’re looking for expert guidance with an inherited annuity, consider working with a financial advisor.
Understanding Inherited Annuities
When someone purchases an annuity contract, they may have the option to name one or more beneficiaries. Those beneficiaries are then eligible to receive payments from the annuity if the original annuitant passes away. There are a few reasons why someone might choose to name an annuity beneficiary.
First, if a beneficiary is not named or if it’s not a joint and survivor annuity, which would continue paying benefits to a surviving spouse, any remaining money in the annuity would be lost. The financial institution the annuitant purchased the annuity from would get to keep any remaining benefits.
Second, naming beneficiaries to an annuity is one way to create a financial legacy for loved ones. If you have adult children, for example, you may want to name them as beneficiaries to a joint and survivor annuity so that they can receive any remaining benefits once you and your spouse die. An annuity can be used to supplement other financial resources, such as life insurance or a trust, inside of an estate plan.
It’s important to note that some annuities can’t be inherited. If you purchase a single life or life-only annuity, for example, the annuity would only pay benefits to you during your lifetime. There would be no death benefit to pass on to a beneficiary.
How Inherited Annuities Are Taxed at Death
Understanding how inherited annuities are taxed starts with knowing the difference between qualified and non-qualified annuities. A qualified annuity is an annuity that’s purchased using pre-tax dollars through a tax-advantaged account, such as a 401(k) plan or an individual retirement account (IRA). Any distributions paid to the annuitant from a qualified annuity are treated as taxable income in the year they’re received.
In almost all cases, withdrawals made before age 59 ½ are subject to a 10% early withdrawal penalty. Qualified annuities must also follow the required minimum distribution (RMD) rules. A non-qualified annuity, on the other hand, is funded using after-tax dollars.
However, any growth or earnings on your initial investment are tax-deferred. In other words, you have to pay ordinary income tax on the earnings part of your distributions. However, there is no 10% early withdrawal penalty to worry about and you don’t have to deal with RMDs either.
Tax Rules for Inherited Annuities
Taxes on an inherited annuity are usually dictated by your beneficiary status and how you receive payouts. If you’re the spouse of the original annuitant, then you can choose to continue receiving payments according to the annuity schedule. In that instance, any taxes owed on distributions would be deferred until you receive them.
Paying Taxes on an Inherited Annuity From a Deceased Parent or Non-Spouse
The rules work differently if you inherit an annuity and you are not the annuitant’s spouse. When you inherit an annuity from a deceased parent, the funds in the account will be taxed as ordinary income. When you have to pay taxes depends on how you decide to receive distributions from the annuity.
If distributions have not yet begun, there are generally four ways to take money from an inherited annuity:
Add a note below the table and a qualifier in the header row. Here is how it would look:
If distributions have not yet begun, there are generally four ways to take money from an inherited nonqualified annuity:
| Payout Option | How It Works |
|---|---|
| Lump Sum | You could opt to take any money remaining in an inherited annuity in one lump sum. You’d have to pay any taxes due on the taxable portion of the benefits at the time you receive them. |
| Five-Year Rule | The five-year rule lets you spread out payments from an inherited annuity over five years, paying taxes on distributions as you go. |
| Nonqualified Stretch | You take the remainder of the contract and stretch annuity payments out over the rest of your life. Your life expectancy sets the basis for your actual payment amount and schedule. |
| Periodic or Annuitized Payout | You get payments for the remainder of your life, but the payment amount is not based on your life expectancy. |
If you inherit a qualified annuity, meaning one held inside an IRA or other retirement account, different rules apply. Under the SECURE Act, most non-spouse beneficiaries must withdraw the entire balance by December 31 of the tenth year following the original owner’s death.
How to Avoid Paying Taxes on an Inherited Annuity
Unfortunately, you can’t completely avoid paying taxes when you inherit an annuity. But there are things you can do to defer payment on what you inherit. Here are some of the most common methods to avoid paying taxes on an inherited annuity:
- Surviving spouse: Exercising your option to continue receiving payments as usual if you’re a surviving spouse is one way to maintain the tax-deferred status of an inherited annuity. Similarly, you can lower your tax exposure by opting for nonqualified stretch payments based on your life expectancy or periodic payments if you’re inheriting an annuity as a non-spouse.
- 1035 exchange: In this method, you exchange the annuity you inherit for another annuity. The catch is that the exchange has to be similar. In other words, you can’t exchange a qualified for a nonqualified annuity or vice versa to try and escape taxation. The main reason for considering a 1035 exchange of an inherited annuity would be to switch to an annuity with more favorable terms or benefits.
- Rollover into an inherited IRA: This is only an option if you also inherited the deceased annuitant’s IRA. If you inherit your father’s annuity, for example, but he didn’t have an IRA or he named your sibling as a beneficiary, you wouldn’t be able to roll the annuity over to a personal IRA in your name. Also, note that you can only roll over an inherited annuity to an inherited IRA if the annuity funds are qualified. Assuming you’re able to roll an inherited annuity over, you’d then be subject to inherited IRA tax rules.
It’s important to work with a professional if you’re trying to legally avoid taxes and set your finances up for long-term success. A financial advisor can help you understand what your options are for retirement and ensure you’re able to properly manage your overall investment portfolio.
Use our calculator to understand how tax brackets apply to your earnings.
How the Size of an Inherited Annuity Affects Your Tax Strategy
The payout option that makes the most financial sense depends less on the annuity itself and more on how the distributions interact with everything else on your tax return. Two beneficiaries inheriting the same annuity can end up with very different tax bills depending on their income, filing status and other assets.
The core issue is that inherited annuity distributions are taxed as ordinary income. That means every dollar you receive gets stacked on top of your wages, Social Security, retirement account withdrawals and any other taxable income for the year. The more you take in a single year, the higher the rate applied to the top portion of that income.
For a beneficiary with modest income, stretching payments over a lifetime can keep annual distributions within a lower tax bracket. Someone receiving $30,000 per year from Social Security and a small pension who inherits a $300,000 annuity might be able to take $15,000 to $20,000 per year from the annuity without pushing into a significantly higher bracket. Over a 20-year stretch, the total tax paid on those distributions may be far less than what a lump sum would cost in the year of inheritance.
For a beneficiary already earning a high income, the calculus shifts. Adding large annuity distributions on top of a $200,000 salary means those distributions are taxed at the higher rates from the first dollar. In that situation, the stretch option still spreads the pain over time, but each year’s distribution hits at the same elevated rate. A 1035 exchange into a new annuity may make more sense, deferring the tax further while potentially improving the contract terms.
A lump sum makes the most financial sense in a narrow set of circumstances. If the annuity is small relative to the beneficiary’s overall financial picture, if the beneficiary is in a low income year due to job loss or retirement, or if the annuity has unfavorable terms that make ongoing payments unattractive, taking everything at once and paying the tax may be cleaner than managing distributions over years. The key is modeling what the lump sum actually costs in the year of receipt before making that decision, not after.
The five-year rule sits between a lump sum and a lifetime stretch. It works best when the beneficiary expects their income to drop significantly within a few years, allowing them to time the larger distributions into lower-income years. A beneficiary who is still working now but plans to retire in two years might take minimal distributions in years one and two, then accelerate in years three through five when their income is lower and the tax rate on those distributions is reduced.
Common Mistakes Beneficiaries Make With Inherited Annuities
Most costly mistakes with inherited annuities happen in the first few weeks, before the beneficiary has had time to understand what they actually inherited or what their options are.
Taking a lump sum by default is the most expensive mistake. Insurance companies often present the lump sum as the simplest option, and beneficiaries who are grieving and overwhelmed frequently accept it without modeling the tax consequences. A $200,000 lump sum added to a year of normal income can push a beneficiary into a bracket they have never been in before, resulting in a tax bill that a different payout election would have substantially reduced.
Missing the election deadline is a close second. Most annuity contracts require beneficiaries to choose a payout option within a specific window after the annuitant’s death, often 30 to 60 days. Beneficiaries who do not act in time may be defaulted into an option they would not have chosen, with limited ability to change course afterward.
Assuming an inherited annuity works like an inherited IRA leads to similar problems, but the rules differ in meaningful ways depending on whether the annuity is qualified or nonqualified. For nonqualified annuities, the stretch option is based on the beneficiary’s life expectancy under the annuity contract terms rather than the 10-year rule that applies to most inherited IRAs. For qualified annuities held inside an IRA or other retirement account, the SECURE Act of 2019 eliminated the stretch for most non-spouse beneficiaries, replacing it with the same 10-year depletion rule that governs inherited IRAs. Conflating the two can result in a beneficiary taking distributions on the wrong schedule and either missing required amounts or paying tax earlier than necessary.
Failing to check whether the annuity is qualified or non-qualified before making any decisions is another gap that costs people money. The tax treatment of each is fundamentally different, and the strategies available to reduce the tax burden vary accordingly. A beneficiary who does not know which type they inherited cannot evaluate their options accurately.
Inheriting an annuity and doing nothing is also a mistake. Some beneficiaries delay making a payout election because the decision feels complicated, which can result in a default distribution that triggers taxes immediately. Acting promptly, even if that action is simply calling the insurance company to ask about available options and deadlines, is always better than waiting.
Bottom Line
Inheriting an annuity can be a financial boon, but it often comes with tax implications that require careful consideration. To minimize the tax burden, it’s crucial to understand the options available, as discussed above. By carefully evaluating these strategies, beneficiaries can make informed decisions that align with their financial goals while effectively managing the tax responsibilities associated with an inherited annuity.
Tips on Inheritance
- Do you have questions about your inheritance? A financial advisor can help with this. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re considering purchasing an annuity, learn how different annuity options work. Ask if you can name a beneficiary and how payments will continue if you’re buying a joint and survivor annuity. Also, research the various costs involved in purchasing and owning an annuity.
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