Inherited Annuity? Know your Options and the Tax Implications

So, you inherited an annuity. Now what?

Let’s walk through what that actually means—and what you can do with it.

When most people think of an inheritance, they picture a house, an investment account, or maybe a life insurance policy. But annuities are becoming a more common part of estate planning—and they come with their own set of rules, especially around taxes.

If you've inherited one—or expect to—you’ll want to understand how it works before making any decisions. Here’s a breakdown to help you get started.

What Is an Inherited Annuity?

An annuity is a contract with an insurance company. The original owner contributed money—either in a lump sum or over time—and in return, the insurance company agreed to provide income, either right away or in the future.

When the owner passes away, any remaining value in the annuity goes to the named beneficiary. That’s where you come in.

Qualified vs. Non-Qualified: Why It Matters

One of the first things to figure out is whether the annuity is qualified or non-qualified, because that affects how the money is taxed.

• Qualified annuities are part of a retirement account, like an IRA or 401(k). The original contributions were made with pre-tax dollars, so distributions—whether to the original owner or a beneficiary—are fully taxable as ordinary income. Under the SECURE Act, most non-spouse beneficiaries must withdraw the entire amount within 10 years.

• Non-qualified annuities are funded with after-tax money and are not part of a retirement plan. Only the earnings are taxed when you withdraw them; the original investment, also called the basis, is returned to you tax-free.

  
  

Knowing the difference helps you plan for the potential tax impact.

Was the Annuity Annuitized?

Another key question: had the original owner already started receiving income payments?

• If the annuity was not annuitized, meaning it was still in the accumulation phase, you’ll typically have more flexibility in how and when you receive the money.

• If it was already annuitized, your options may be limited. In many cases, income payments end when the owner dies—unless the contract specifically allows them to continue to a beneficiary.

  
  

Check the contract to see what applies in your situation.

How Is an Inherited Annuity Taxed?

This is where inherited annuities differ from other types of inheritance. Unlike stocks or real estate, annuities don’t receive a step-up in cost basis. That means you could owe ordinary income tax on any gains that haven’t already been taxed.

• If it’s a qualified annuity, the full amount is taxable.

• If it’s non-qualified, only the earnings portion is taxable.

  
  

Important note: While many investments are taxed at more favorable capital gains rates, non-qualified annuity earnings are taxed as ordinary income, not as capital gains. Distributions typically follow the Last In, First Out (LIFO) method—meaning taxable earnings come out first, and your original investment comes out later, tax-free.

How you take the money out—whether all at once or over time—will affect how much tax you owe and when you owe it.

What Are Your Options?

The choices available to you depend on several factors, including the type of annuity, whether it was annuitized, and your relationship to the original owner. Here are the most common options for beneficiaries:

1. Lump-Sum Payout

This gives you immediate access to the full value of the annuity. The tradeoff? You’ll pay income tax on any taxable portion all in one year, which could push you into a higher tax bracket.

2. Distribute Within a Time Limit (5- or 10-Year Rule)

• With the 5-year rule (more common with non-qualified annuities), you can take withdrawals whenever you want, as long as the entire value is distributed within five years.

• With qualified annuities, most non-spouse beneficiaries must follow the 10-year rule, withdrawing the full amount by the end of the tenth year after the owner’s death.

  
  

This gives you some flexibility to spread out the tax impact across several years.

3. Stretch Payout (Life Expectancy Method)

In some cases, particularly with non-qualified annuities, you may be able to “stretch” the payout over your own life expectancy. This allows you to take smaller, annual distributions—and spread the tax liability out over time. Not all contracts offer this option, and recent rule changes have limited it for qualified accounts.

If it’s available, this can be a great strategy to keep more money growing tax-deferred while avoiding a big tax hit all at once.

4. Annuitization or Periodic Payments

Some contracts allow you to annuitize the inherited annuity, converting it into a stream of income over a set period or for life. This can help create predictable income, though once you annuitize, the schedule usually can’t be changed.

5. Spousal Continuation (If You’re the Surviving Spouse)

Spouses often have the most flexibility. You may be able to assume the annuity as your own, keep the tax deferral intact, and decide later when and how to begin withdrawals.

We’re Here If You Need a Hand

Inherited annuities can be tricky, and it’s not always clear what the best next step is. If you’re sorting through your options and want to talk it through, we’re always happy to help you think it over.