Retirement Literacy Foundation · Annuity Education

Inherited Annuity Taxes: What Beneficiaries Owe and Their Options

By Hans Goldstein, founder, Retirement Literacy Foundation · Updated October 8, 2026

Short answer: An inherited annuity does not get a step-up in basis. The gain built up in the contract is taxable to the beneficiary as ordinary income when it is paid out. What you choose as a beneficiary (lump sum, payout over five years, or payments over your lifetime) decides when that tax is paid.

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Why there is no step-up

Stocks, real estate and most other assets get a new cost basis at death, which can wipe out the gain. Annuities are different: the untaxed growth is income in respect of a decedent, so the beneficiary pays ordinary income tax on it as it comes out. The original owner's premiums (for a non-qualified annuity) still come back tax-free.

Options for a non-qualified annuity

Surviving spouse: can usually continue the contract as the new owner and keep deferring tax (spousal continuation).
Lump sum: take everything now. All of the gain is taxed in one year, which can push you into a higher bracket.
Five-year rule: take the money any time within five years of the owner's death (IRC section 72(s)), which lets you spread the gain over several tax years.
Payments over your life expectancy (often called a stretch or "nonqualified stretch"): payments must start within one year of death. This spreads the tax over many years. Not every contract offers it.

The 10% early withdrawal tax does not apply to death benefits, whatever the beneficiary's age.

Options for an annuity inside an IRA

An annuity held in an inherited IRA follows the inherited IRA rules. Most non-spouse beneficiaries must empty the account within 10 years, and if the owner had already started required distributions, yearly withdrawals are also required. Spouses, minor children, disabled or chronically ill beneficiaries and people not more than 10 years younger than the owner have more options. See the inherited IRA 10-year rule and the inherited IRA RMD calculator.

Planning points

Spreading the payout over several years usually lowers the total tax, and can keep you under IRMAA lines if you are on Medicare.
If the death benefit is larger than the account value (an enhanced death benefit), the extra amount is also taxable income.
Check the beneficiary designation: the annuity passes by contract, not by your will.

Common questions

Is an inherited annuity taxable?

Yes, the gain is. The beneficiary pays ordinary income tax on the growth above the original owner's premiums (for a non-qualified annuity), or on the whole amount for an annuity held in an IRA.

Do you pay the 10% penalty on an inherited annuity?

No. Distributions paid because of the owner's death are exempt from the 10% early withdrawal tax.

Can a beneficiary do a 1035 exchange?

Under IRS private letter rulings, a non-spouse beneficiary has been allowed to exchange an inherited non-qualified annuity into a new inherited annuity if the required distribution schedule is kept. Ask the insurer and a tax professional before relying on it.

More on annuities: How Do Annuities Work? A Plain-English Guide · How Are Annuities Taxed? · 1035 Exchange · Annuities in an IRA · Annuity Surrender Charges and How to Get Out of an Annuity · Types of Annuities and Their Pros and Cons · What Is a MYGA? Multi-Year Guaranteed Annuities Explained · Fixed Index Annuity Explained · Immediate Annuity (SPIA) Explained · Variable Annuity Explained · Annuity vs CD

Education only; nothing is sold here and no product is recommended. Hans Goldstein, founder of the Retirement Literacy Foundation, is also a licensed California insurance producer (#4273294). Tax rules depend on your situation; check with a tax professional before acting.