When you inherit an annuity, what you receive and how it’s taxed depend on the type of annuity, how far along the owner was in their payout schedule, and your relationship to that person. Some beneficiaries receive a lump sum, others receive a stream of payments and some must withdraw the balance within a specific timeframe.
How Inherited Annuities Work
An annuity is a contract between an owner and an insurance company. When the owner dies, the insurer pays the remaining value to the beneficiary listed on the contract. That beneficiary can be a spouse, child, other family member, trust or charity.
What happens next depends on whether the annuity was still growing (a deferred annuity) or already paying income (an income annuity) at the time of death, as well as the rules set by the IRS and the contract itself.
What Typically Happens When You Inherit an Annuity
If the annuity was still growing, you may be able to take a lump sum or spread withdrawals over several years. If it was already paying income, you may receive the remaining guaranteed payments or a reduced continuation of those payments. Taxes generally apply to the earnings portion of what you receive.
Your Options When You Inherit a Deferred Annuity
If the annuity owner had not started receiving lifetime income, the beneficiary usually has several options. These options determine the timing of your withdrawals and how much tax you pay each year.
Lump-Sum Withdrawal
You can take the full remaining value at once. This option is simple, but the taxable portion of the withdrawal is included in your income for that year, which may increase your tax bracket.
Example: If you inherit a $120,000 deferred annuity with $40,000 of taxable gains, the entire $40,000 becomes taxable in the year you cash it out.
Withdraw the Balance Over Time
Some beneficiaries may spread withdrawals over a set number of years, depending on when the original owner passed away and whether the beneficiary is a spouse. This allows you to manage taxes more gradually and avoid a large single-year tax bill.
Five-Year Rule
If the annuity owner died before taking required withdrawals and you’re a non-spouse, you may be required to withdraw the full value within five years. You can take money at any time during that window, as long as the entire contract is distributed by the end of year five.
Spousal Continuation
A surviving spouse has more flexibility than other beneficiaries. Instead of inheriting the annuity outright, a spouse can often choose to become the new owner and continue the contract as if it were their own. This keeps the tax treatment intact and avoids forced distributions.
What Happens When You Inherit an Income Annuity
If the owner was already receiving lifetime payments, what you receive depends on the payout option chosen when the contract was purchased.
Payments Continue To You
If the owner selected a payment option with a period certain or a joint-life structure, you may receive the remaining guaranteed payments or continue receiving income for your lifetime.
Payments Stop
If the owner chose life only payments with no guarantees, the payments end at the owner’s death and there is no remaining value for beneficiaries.
Example: A father buys an income annuity with “life with 10-year period certain” payments. He passes away six years into the contract. His daughter, listed as the beneficiary, receives the remaining four years of payments. If he had chosen “life only,” those payments would have ended at his death.
How Inherited Annuities Are Taxed
Annuities are taxed differently from inherited stocks or mutual funds because they do not receive a step-up in basis. That means the earnings portion of every withdrawal is taxed as ordinary income.
The amount you owe depends on:
- How much of the annuity represents growth
- Whether it was funded with pre-tax or after-tax dollars
- How you choose to take your distributions
- Whether you are a spouse or non-spouse beneficiary
A lump sum results in immediate taxation of all gains, while spreading payments out typically spreads out the tax bill as well.
Example: If you inherit a $90,000 annuity that was funded with $60,000 of after-tax premium, the $30,000 in earnings is taxable. If you take a lump sum, the full $30,000 is included in your income that year. If you take payments over 10 years, roughly one-tenth of the taxable amount is reported annually.
Curious How Today’s Annuity Rates Compare?
Inheriting an Annuity as a Spouse
Spouses receive the broadest range of options. They can:
- Take ownership of the contract
- Roll it into their own annuity
- Start or continue income payments
- Take a lump sum if preferred
Spousal continuation is often the most tax-efficient choice because it preserves the annuity’s tax-deferred status.
One of my clients in Connecticut inherited an annuity when her husband passed away. Since they were married, she just assumed the contract. If it had been a joint income payout, nothing would have changed except the ownership. Since it was a MYGA contract, the only thing that changed was the name of the owner.
John Stevenson, CFFOwner and Advisor at Stevenson Retirement SolutionsJohn Stevenson, a Certified Financial Fiduciary®️, specializes in securing retirements with tax-free accounts. With a focus on guaranteed retirement, he’s ensured none of his clients suffer from market fluctuations. As a renowned educator and podcast host, John empowers thousands weekly, sharing his expertise in minimizing taxes and protecting against financial downturns.
Inheriting an Annuity as a Non-Spouse
Non-spouse beneficiaries must follow the IRS distribution rules, which may require full payout within a certain number of years. They cannot assume ownership of the annuity as a spouse can.
This often means weighing the tax impact of a lump sum versus spreading withdrawals.
Inherited Annuities and the 10-Year Rule
Some inherited annuities fall under the SECURE Act’s 10-year rule, requiring the entire balance to be withdrawn within 10 years for most non-spouse beneficiaries. However, exceptions exist for certain “eligible designated beneficiaries,” such as minor children, disabled individuals and beneficiaries close in age to the deceased.
Contract language and timing matter, so beneficiaries should review the annuity paperwork closely or consult a professional.
What to Do if You Inherit an Annuity
Inheriting an annuity can provide meaningful financial support, but it also brings choices that affect taxes and long-term value. The best approach depends on your relationship to the owner, the type of annuity and how quickly you need the funds.
Take time to review your options before withdrawing money. A small change, such as spacing distributions over several years instead of taking a lump sum, can significantly reduce taxes and preserve more of the value left to you.
Frequently Asked Questions
Annuities are insurance products that grow a lump sum premium over a set number of years before converting it into a stream of income payments.
When an annuity is passed down after death, the beneficiary can choose to receive the annuity’s value in a lump sum payout or stretch the payments out over several years.
Payouts for inherited annuities can be a lump sum that is taxed all at once, or a stretched payment schedule that spreads out the payouts and the tax burden.
Usually, you will have the option to receive a lump sum payment from an inherited annuity.
