How Does Inheriting an Annuity Work?

When someone inherits an annuity, they receive the remaining payments or account value from a contract originally owned by another person. The payout options and tax treatment depend on the relationship to the deceased and whether the annuity was qualified or non-qualified. Spouses can often continue the contract in their own name, while non-spouse beneficiaries may need to withdraw the balance within a set timeframe under the SECURE Act. Inherited annuities can provide income, but the rules governing them vary based on ownership type and distribution choices.

Do you have questions about how to handle an inherited annuity? Connect with a financial advisor to see how they can help.

Options When Inheriting a Non-Qualified Annuity

Non-qualified annuities are contracts purchased with after-tax dollars, meaning contributions are not tax-deductible, but earnings grow tax-deferred until withdrawn. When a non-qualified annuity is inherited, beneficiaries generally have several ways to take payouts.

The available choices depend on whether the beneficiary is a spouse, a non-spouse individual, or a non-individual such as a trust or estate, with each option carrying its own rules and tax treatment.

“Inherited annuities can be complicated to interpret because of nuanced tax rules that treat beneficiaries differently depending on their relationship to the deceased person,” said Tanza Loudenback, a Certified Financial Planner™ (CFP®).

Spousal Continuation

A surviving spouse can continue the annuity in their own name. This allows them to assume ownership of the contract and keep the tax-deferred status. The annuity essentially becomes theirs, and they can continue to take distributions or let it grow. This option is not available to non-spouse beneficiaries.

Five-Year Rule

Non-spouse beneficiaries often use the five-year rule, which requires the full balance of the annuity to be distributed within five years of the original owner’s death. Withdrawals can be made at any time during that period, but all funds must be out of the annuity by the deadline. Trusts and estates also typically fall under this rule.

Non-Qualified Stretch (Life Expectancy Method)

Some individual beneficiaries may be able to take payouts based on their own life expectancy, spreading withdrawals over time. This option allows continued tax deferral but is not available to non-individual beneficiaries such as trusts or estates. The SECURE Act eliminated many stretch provisions for retirement accounts but did not change them for non-qualified annuities, making this method still possible in certain cases.

Lump-Sum Distribution

Any beneficiary (spouses, non-spouses, trusts or estate) can elect to take the annuity as a single lump-sum payment. While this provides immediate access to the funds, the entire taxable portion of the annuity becomes taxable in the year of distribution, which may create a significant tax bill.

Options When Inheriting a Qualified Annuity

Qualified annuities are funded with pre-tax dollars, usually through retirement plans like IRAs or 401(k)s. Because they are tied to retirement accounts, the payout options for beneficiaries are governed by tax law. The available methods depend on whether the beneficiary is a spouse, a non-spouse individual or a non-individual such as a trust or estate.

Spousal Continuation or Rollover

A surviving spouse who is named as the sole beneficiary of a qualified annuity can roll the annuity into their own IRA or qualified plan. This gives them full ownership and allows them to delay required minimum distributions (RMDs) until they reach the applicable RMD age. They can also choose to remain a beneficiary and take distributions based on their life expectancy. These options are not available to non-spouse beneficiaries.

10-Year Rule

Most non-spouse beneficiaries must withdraw the entire balance of the qualified annuity within 10 years of the original owner’s death. Withdrawals can be made at any pace during that period, but all funds must be distributed by the end of the 10th year. This rule was introduced under the SECURE Act and applies broadly to most individual beneficiaries.

However, certain non-spouse beneficiaries qualify for an exception to the 10-year rule. Eligible Designated Beneficiaries include minor children of the account owner (until they reach adulthood), disabled or chronically ill individuals and beneficiaries less than 10 years younger than the decedent. EDBs can stretch distributions over their life expectancy, which may reduce the annual tax impact.

Non-Individual Beneficiaries

If the beneficiary is a trust, estate, or other entity, the annuity must usually be distributed under the five-year rule (if the owner died before beginning RMDs) or at least as quickly as the original owner’s remaining life expectancy (if they had already started RMDs). These rules prevent ongoing tax deferral when the annuity is inherited by a non-individual.

Lump-Sum Distribution

Any beneficiary can elect a lump-sum payout. With qualified annuities, the entire amount is generally taxable as ordinary income in the year received. This can result in a significant tax obligation, especially if the annuity balance is large.

Do I Pay Taxes on an Inherited Annuity?

The taxation of an inherited annuity hinges on how the IRS distinguishes between principal and earnings, as well as the type of contract.

With qualified annuities, every dollar distributed is taxable because the entire account was funded with pre-tax contributions. This can push beneficiaries into a higher tax bracket if large withdrawals are taken in a single year. For example, inheriting a $200,000 qualified annuity and taking it as a lump sum could increase taxable income enough to trigger additional Medicare surtaxes or phaseouts of deductions.

With non-qualified annuities, the IRS applies a “last-in, first-out” (LIFO) rule. Earnings come out first and are taxed as ordinary income until they’re fully depleted, followed by a tax-free distribution of the original contributions. A $150,000 contract with $50,000 in gains would subject the first $50,000 of withdrawals to income tax before the remaining $100,000 could be accessed tax-free.

Bottom Line

Inheriting an annuity means weighing different payout structures alongside the tax rules that apply to them. The choices available can shift depending on whether the contract was funded with pre- or after-tax dollars, and on the relationship of the beneficiary to the original annuitant. Some options provide steady income over time, while others accelerate distributions but create larger tax obligations in a single year.

“If you’ve inherited an annuity, first find out if it’s qualified or non-qualified,” said Loudenback. “This will inform your payout options and tax responsibility, which you can discuss with a financial advisor to decide the best path forward.”

Tips for Managing an Inheritance

Professional advice can help you see all aspects of an inherited annuity and decide on the best course to take. Finding a qualified 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 inheriting an annuity, treat it like any other inherited asset and consider where it fits into your larger financial plan. Specifically, you should think about whether it’s better to use it for short-term expenses or as extra retirement income. If you inherit an annuity from a spouse, be aware you have only 60 days to choose a lifetime payment structure.

Tanza Loudenback, a Certified Financial Planner™ (CFP®), provided the quotes used in this article. Please note that Tanza is not a participant in SmartAsset AMP, is not an employee of SmartAsset and has been compensated. The opinions voiced in the quote(s) are for general information only and are not intended to provide specific advice or recommendations.