Inherited Annuity Taxes: What Beneficiaries Need to Know

The Key Difference From Other Inherited Assets

Many inherited assets, like stocks or real estate, get a "step-up in basis" at death — meaning the beneficiary's taxable gain is calculated from the value at the date of death, not the original purchase price. Annuities generally do not receive this step-up. That's the single most important thing to understand as a beneficiary, and it surprises a lot of people.

How the Taxable Amount Is Determined

For a non-qualified annuity, the beneficiary generally owes ordinary income tax on the amount that exceeds the original owner's cost basis (their deposit) — essentially the same growth portion that would have been taxable to the original owner. For a qualified annuity (IRA-funded), the entire amount is typically taxable as ordinary income when withdrawn, just as it would have been for the original owner.

Your Options as a Beneficiary

Depending on the contract and whether you're a spouse or not, you typically have a few paths:

• Lump sum — take the full death benefit at once, with the taxable portion due in that tax year
• Five-year rule — spread withdrawals over up to five years
• Life-expectancy payments — some contracts allow stretching payments over your own life expectancy, spreading the tax impact much further
• Spousal continuation — if you're the surviving spouse, continuing the contract as your own, preserving tax deferral rather than triggering a taxable event now

We cover the full mechanics of these options in our guide to what happens to an annuity when the owner dies.

Why the Payout Method Matters So Much

Taking a large inherited annuity as a single lump sum can push a beneficiary into a significantly higher tax bracket for that year — sometimes substantially higher than if the same income had been spread over several years. This is often the single biggest decision an inheriting beneficiary makes, and it's worth thinking through carefully rather than defaulting to the simplest-sounding option.

Multiple Beneficiaries

If a contract names more than one beneficiary, each beneficiary's share is generally treated separately for tax purposes — each person can often choose their own payout method independent of what the others decide, though the specifics depend on the contract and carrier.

State Taxes May Also Apply

Beyond federal tax treatment, some states impose their own inheritance or estate tax rules that can apply to inherited annuities. This varies significantly by state, which is exactly the kind of detail worth confirming with a tax professional familiar with your specific state.

The Bottom Line

Inheriting an annuity isn't the same as inheriting most other assets — there's no step-up in basis, and the payout method you choose can meaningfully change your tax bill. Before taking any action, it's worth understanding all the available options and, ideally, discussing the decision with a tax professional before the money moves.