Inheriting an annuity is one of the questions I hear most often from families after a parent passes away. It can be a valuable asset, but the rules are different from inheriting a brokerage account or a house, and some of the most important decisions come with deadlines. Here is what you should know before you call the insurance company.
Start by figuring out what kind of annuity you inherited
The first question is where the annuity was held, because the tax rules follow the account, not the product.
- Non-qualified annuity: bought with money that was already taxed, outside of any retirement account. Most of this article covers this type.
- Qualified annuity: held inside an IRA, 401(k), or other retirement plan. These follow the inherited retirement account rules covered further down.
Next, look at the contract itself. Is it a fixed, variable, or indexed annuity? Had the owner already started receiving income payments (annuitized), or was it still in the savings phase? Are there death benefit riders, surrender charges, or guarantees that only apply under certain payout options? The insurance company can send you a copy of the contract and a death claim packet with your options spelled out.
How an inherited annuity is taxed
This is where many beneficiaries get surprised. With a non-qualified annuity, the original owner’s contributions (the cost basis) come back to you tax-free. The growth above that amount is taxed as ordinary income when you withdraw it, not at the lower capital gains rates.
Unlike stocks or real estate, an annuity does not get a step-up in cost basis at death. If your parent invested $100,000 and the contract is worth $160,000 when you inherit it, the $60,000 of growth will be taxable to you as it comes out. How and when you take it out determines which tax years that income lands in.
The one piece of good news: the 10% early withdrawal penalty that normally applies before age 59½ does not apply to death benefit distributions paid to a beneficiary, regardless of your age.
For a qualified annuity held in a traditional IRA or 401(k), the entire distribution is generally taxable as ordinary income, because the money went in before taxes.
Your options if you are the surviving spouse
A surviving spouse who is the sole beneficiary usually has the most flexibility. You can elect to continue the contract in your own name, which keeps the tax deferral going and does not require any distributions. From that point on, you are treated as the owner, so withdrawals you take before age 59½ could be subject to the 10% penalty.
You can also take the death benefit as a lump sum or use the same payout options available to other beneficiaries. The right choice depends on whether you need the income now and how the contract’s fees and guarantees compare with other options.
Your options as a non-spouse beneficiary
Children, other relatives, and friends who inherit a non-qualified annuity generally choose among three paths:
- Lump sum. You receive the full value at once. It is simple, but all of the taxable growth is reported in a single year, which can push you into a higher tax bracket.
- The 5-year rule. You must withdraw the entire balance by the end of the fifth year after the owner’s death. There are no required annual amounts, so you can take money out in whatever pattern makes sense for your taxes, as long as the account is empty by the deadline.
- Stretch over your life expectancy. You take payments based on your own life expectancy, which spreads the taxable income over many years and lets the rest of the money keep growing tax-deferred. To use this option, distributions must begin within one year of the owner’s death. Miss that window and you are generally limited to the 5-year rule.
Going back to the example above, taking a $160,000 lump sum puts $60,000 of taxable income on one year’s return. Spreading withdrawals over five years puts roughly $12,000 of that growth on each year’s return. A life-expectancy stretch spreads it thinner still. For many beneficiaries who are still working, that difference can be significant.
If the original owner had already annuitized the contract, your choices may be narrower. Payments generally continue under the terms that were already chosen, for example the remaining guaranteed period.
Annuities held in an IRA or 401(k)
When the annuity sits inside a retirement account, the inherited IRA rules apply instead. A surviving spouse can generally roll it into their own IRA or treat it as their own. Most non-spouse beneficiaries must empty the account within 10 years of the owner’s death under the SECURE Act. In some cases, annual distributions are also required during that 10-year window.
Certain eligible beneficiaries can still stretch distributions over their life expectancy. These include a minor child of the owner, a beneficiary who is disabled or chronically ill, and anyone not more than 10 years younger than the owner. I cover the broader IRA rules in Brush Up On Your IRA Facts.
Can you move an inherited annuity to a different company?
Yes, in many cases. The IRS has ruled (Private Letter Ruling 201330016) that a beneficiary who inherits a non-qualified annuity can complete a 1035 exchange into a different annuity contract without triggering tax. This can make sense if the inherited contract has high fees or limited investment choices.
Two cautions. First, the exchange does not reset the clock. The new contract still has to follow the 5-year rule or the life-expectancy stretch that applied to the original. Second, not every insurance company accepts inherited annuity exchanges, and the paperwork has to be handled carefully so it is not treated as a taxable distribution.
Questions to ask before you decide
- Do I need this money now, or can it keep growing?
- How will each payout option affect my tax bracket this year and in future years?
- Is the contract still in a surrender period, and what are the ongoing fees?
- Are there riders or guarantees that are only paid under certain options?
- Have I met the one-year deadline if I want to stretch payments?
- Once the money is mine, do my own beneficiary designations reflect my wishes?
If you have inherited a variable annuity, my article on variable annuities explains how the fees and guarantees in these contracts typically work.
Get help before you sign the claim forms
The death claim form will ask you to choose a payout option, and some of those choices cannot be undone. Before you sign it, sit down with a financial advisor and your tax professional to compare the options side by side. A few hours of planning can keep a meaningful part of your inheritance from going to taxes sooner than it needs to.
If you are working through an inheritance more broadly, Making Your Inheritance Last a Lifetime covers the bigger picture.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
