Inherited Annuity: Tax Rules and Planning Options

First: is it a qualified or non-qualified annuity?

The tax treatment of an inherited annuity depends entirely on which type of annuity you received. They look similar from the outside, but the rules are completely different:

To find out which you have: ask the insurance company or look at the account statement. A non-qualified annuity is held in a taxable account; a qualified annuity is custodied inside an IRA or employer plan and will appear on the beneficiary's IRA paperwork. If you inherited a qualified annuity inside an IRA, treat it as an inherited IRA—see our Inheritance Planning guide for those rules.

The rest of this guide covers non-qualified inherited annuities.

The LIFO rule: earnings come out first, basis comes out last

Non-qualified annuities are taxed under a last-in, first-out (LIFO) rule. Any accumulated growth—the earnings that built up inside the contract over the owner's lifetime—is considered distributed before the original premium (basis) is returned.¹

This has a counterintuitive implication: even a modest partial withdrawal is likely to be entirely taxable if the contract holds significant earnings. A contract purchased for $200,000 that grew to $500,000 contains $300,000 of embedded taxable income. Every dollar withdrawn until that $300,000 is exhausted is ordinary income.

There is no step-up in basis at death for inherited non-qualified annuities. Unlike a taxable brokerage account—where the date-of-death fair market value becomes the heir's new basis under IRC §1014—an inherited annuity carries the original owner's cost basis forward. All the deferred growth remains embedded as future ordinary income for the beneficiary.

No 10% early withdrawal penalty

Distributions from an inherited non-qualified annuity are exempt from the 10% additional tax that normally applies to annuity withdrawals taken before age 59½. Under IRC §72(q)(2)(D), the 10% penalty does not apply to amounts received by a beneficiary on or after the death of the holder.¹ You can access the money at any age without penalty—though the ordinary income tax still applies to the earnings portion.

Distribution options under IRC §72(s)

IRC §72(s) sets the required distribution rules for inherited non-qualified annuities. Your options depend on whether you are the spouse or a non-spouse beneficiary.

Surviving spouse

A surviving spouse named as the designated beneficiary has the most flexibility. Under §72(s)(3), a spouse may elect to become the new owner of the contract and continue it as if they had been the original holder.¹ No distributions are required, the tax-deferred growth continues, and the spouse can name their own beneficiaries. This is typically the best option for a spouse who does not need the money immediately—it preserves the deferral and avoids forcing income into a high-bracket year.

Alternatively, a spouse can take distributions under the same 5-year rule or stretch election available to non-spouse beneficiaries (see below). If the spouse needs immediate cash or has low income in the near term, taking structured distributions can make sense—but the continuation option should be modeled first.

Non-spouse beneficiaries: the 5-year rule (default)

If no election is made, the default rule requires the full contract value to be distributed by December 31 of the fifth year following the owner's death.³ There are no required annual minimums during the 5-year period—you can take the money in any pattern (one lump sum, multiple partial withdrawals, or everything in year 5)—but the full value must be out by the deadline.

The 5-year rule is often the worst tax outcome: deferring to a single large withdrawal in year 5 concentrates all the earnings in one tax year, potentially pushing income to the 37% bracket and triggering IRMAA surcharges two years later. However, spreading withdrawals evenly across five years can work well if your annual income is moderate.

The stretch option: life-expectancy payments

Non-spouse beneficiaries may elect to receive distributions over their life expectancy—sometimes called the "stretch"—provided two conditions are met:³

1. The first distribution must begin no later than one year after the owner's death.
2. The election must typically be made within a specific window—often 60 days from the date you file the beneficiary claim with the insurance company. Miss the window and the 5-year rule applies automatically.

Life-expectancy payments spread the taxable income over potentially decades, keeping each annual distribution in a lower bracket. For a younger beneficiary inheriting a large contract, the stretch option can result in significantly less total tax than either a lump sum or the 5-year rule. It also reduces IRMAA exposure by keeping annual income below the tier thresholds.

The payment schedule uses the IRS Single Life Expectancy Table (the same table used for inherited IRAs before SECURE 2.0). The annual minimum is calculated as the contract value divided by the remaining life expectancy factor. You may always take more than the minimum.

Surrender charges: check the contract before electing

Most life insurance companies waive surrender charges when the original owner dies—beneficiaries can access the full death benefit value without a surrender penalty. However, some contracts do impose surrender charges on inherited distributions, particularly if the contract is in an early surrender charge period.

Before making any distribution election, request the current surrender charge schedule from the insurance company. If a surrender charge applies to a lump sum but is waived on annuitized or stretch payments, the stretch option may be preferred for that reason alone, independent of the tax analysis.

Also ask whether the contract has a death benefit guarantee that may exceed the current account value—some annuities guarantee a minimum death benefit (e.g., return of premium or step-up to highest anniversary value) that could be worth more than the current surrender value in a down market.

IRMAA: the two-year income spike

Inherited annuity distributions—since they are ordinary income—can push your Modified Adjusted Gross Income (MAGI) above Medicare's IRMAA thresholds, adding significant Medicare Part B and Part D surcharges two years after the high-income year.⁴

2026 Medicare Part B IRMAA tiers (based on 2024 MAGI):

A beneficiary already on Medicare who takes a $200,000 lump sum could trigger the top IRMAA tier—adding up to $5,844 per person per year in Medicare surcharges two years later. The income spike also does not qualify for a Form SSA-44 appeal (which is limited to qualifying life events such as retirement or divorce, not windfall income).

IRMAA management is one of the strongest arguments for the stretch option or a structured 5-year withdrawal schedule rather than an immediate lump sum, particularly for beneficiaries who are on Medicare or approaching age 65.

Trust beneficiaries: the compressed-bracket trap

If a trust is named as the beneficiary of a non-qualified annuity, the distribution options narrow: only the 5-year rule is available when the beneficiary is an estate, trust, or charity.³ The stretch option based on a beneficiary's life expectancy is not available to trusts.

The tax cost of trust-level accumulation can be severe. In 2026, a trust reaches the 37% federal income tax bracket on ordinary income above just $16,000.⁵ The 3.8% Net Investment Income Tax (NIIT) applies at the same threshold for undistributed net investment income. A trust receiving $200,000 of annuity earnings distributed over five years ($40,000/year) would pay 37% federal tax on nearly all of it—far more than most individual beneficiaries would pay in their own brackets.

If the trust is structured to pass distributions out to individual beneficiaries (a conduit trust or a trust that regularly makes mandatory distributions), the income flows through to the beneficiaries' individual tax returns and is taxed at their lower rates. The trust structure and distribution language matters enormously here. An estate attorney should review whether the trust's terms allow or require income distributions, and a CPA should model whether retaining income in the trust or distributing it to beneficiaries produces a better outcome.

Form 1099-R reporting

The insurance company will issue a Form 1099-R each year distributions are taken. The form shows the gross distribution amount in Box 1, the taxable amount in Box 2a, and the cost basis in Box 5. Box 7 will contain a distribution code indicating the type of distribution—code "4" designates a death distribution, confirming the 10% penalty exemption.

If the insurance company does not track the cost basis accurately (which can happen when a contract was transferred between insurers or when partial withdrawals were taken prior to the owner's death), you may need to reconstruct the basis from the original policy documents and prior year 1099-Rs. Report the taxable amount on Form 1040 as ordinary income; do not treat the earnings as capital gain.

First 90-day plan for inherited annuity recipients

1. Identify the annuity type immediately. Contact the insurance company and confirm: is this inside an IRA or employer plan (qualified), or held in a taxable account (non-qualified)? The rules are different and the clock for some elections starts at the date of death.
2. Do not take a lump sum before modeling the tax cost. The earnings in the contract are ordinary income. A large lump sum can push you to the 37% bracket and trigger two years of IRMAA surcharges. Request a distribution analysis from the insurer before signing any paperwork.
3. Determine the stretch election deadline. Ask the insurance company specifically: how many days do you have to elect life-expectancy distributions, and when must the first payment begin? Deadlines vary by contract and insurer but are typically 60 days from the claims filing or one year from death for first payment. Missing the window forfeits the stretch option permanently.
4. Surviving spouses: evaluate continuation first. The right to continue the contract as the new owner is generally the most flexible option. Get an analysis of what continuation means for your income and estate before electing any distribution method.
5. Review the surrender charge schedule. Ask the insurer for the current surrender charge schedule and whether it is waived at death. If charges apply, factor this into the distribution timing decision.
6. Check for a death benefit guarantee. Some annuities guarantee a minimum death benefit that exceeds the current account value. Ask for both the current account value and the guaranteed death benefit amount before any distribution is taken.
7. Park any distributed funds before investing. If you receive a lump sum—because the stretch election was missed or a partial withdrawal was taken—park the after-tax proceeds in a Treasury money market fund or FDIC-insured account while the investment plan is built. Do not reinvest immediately into a new annuity without independent advice.

What a fee-only advisor does for inherited annuity recipients

An inherited non-qualified annuity involves insurance contract law, income tax planning, and Medicare planning simultaneously. A fee-only sudden-wealth specialist working alongside your CPA can:

• Model the distribution options side-by-side: Calculate the after-tax outcome of a lump sum, 5-year schedule, and stretch election using your actual tax bracket and Medicare status—so you choose the option with the lowest total tax cost, not the easiest one.
• Identify and protect the stretch election deadline: Ensure the paperwork is filed before the window closes. A missed deadline cannot be remedied after the fact.
• IRMAA tier planning: If you are on Medicare or will be within two years, design a distribution schedule that keeps each year's ordinary income below the IRMAA tier boundaries that matter most to your situation.
• Trust distribution coordination: If the trust is the named beneficiary, work with your estate attorney to review whether the trust's terms allow current distributions to beneficiaries and whether the structure can be modified to avoid trust-level compression.
• Integrate with overall financial plan: An inherited annuity is one piece of an inheritance that may include investment accounts, real estate, and other assets. An integrated plan ensures the tax timing from the annuity complements the rest of the picture—not just optimizes it in isolation.

Get matched with a fee-only advisor for inherited annuity planning

The distribution elections for an inherited non-qualified annuity are time-sensitive and often irreversible. A fee-only advisor who specializes in windfall and inheritance planning can model the lump sum, 5-year, and stretch options against your actual tax situation—before any paperwork is signed.

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