Inherited Non-Qualified Annuity: Beneficiary Rules and Taxes

When you inherit a non-qualified annuity, the taxes on inherited non-qualified annuity money work like this: the gain that built up inside the contract is taxed to you as ordinary income when it comes out, and the contract does not get a step-up in basis at death. Your cost basis (the after-tax money the original owner paid in) comes back tax-free. Everything above it is taxable. How fast you owe, and at what rate, depends on whether you’re a surviving spouse, another individual, or a trust, and which payout option you pick.

Why There’s No Step-Up in Basis

Most inherited assets get a “stepped-up” basis equal to fair market value at the date of death, which wipes out the built-in gain. Annuities described in Section 72 are specifically excluded from that rule.¹ The IRS treats the accumulated gain as income in respect of a decedent, a category Congress kept out of the step-up provision. You inherit both the original owner’s cost basis and the untaxed earnings sitting on top of it, and you’re the one who eventually pays income tax on those earnings.²

How the Gain Actually Gets Taxed

Two different ordering rules apply, depending on how the money leaves the contract.

Withdrawals and Lump Sums: Gain First

If the contract hasn’t been annuitized, every dollar you take out is treated as taxable gain until the entire gain has been distributed. Only after that do you start recovering the tax-free basis.² With a full lump sum this ordering is academic, since you receive everything at once and the taxable portion is simply the payout minus the cost basis. It matters more when you’re spreading withdrawals across several years, because the early ones will be almost entirely taxable.

Annuitized Payments: The Exclusion Ratio

If you convert the contract into a stream of periodic payments, each payment is split into a taxable portion and a tax-free portion using an exclusion ratio. The ratio is the original cost basis divided by the total expected return over the payment period.³ With $100,000 of basis and $300,000 of expected total payments, one-third of every check comes back tax-free and two-thirds is ordinary income. Once you’ve recovered the full basis, every payment after that is fully taxable.

If You’re the Surviving Spouse

A surviving spouse named as the sole beneficiary gets the most favorable treatment available. Federal tax law lets the spouse be treated as though they were the original holder of the contract, which is commonly called spousal continuation.⁴ The gain keeps growing tax-deferred, and no tax is due until the spouse eventually withdraws money or begins annuity payments. The spouse carries over the decedent’s cost basis and isn’t subject to the five-year rule or any forced distribution schedule.

Because continuation makes the spouse the legal owner of the contract, the spouse can also perform a Section 1035 exchange into a different annuity without triggering a taxable gain.⁵ That’s useful when the inherited contract has high fees or features that don’t fit.

A spouse can instead take a full lump sum, but the whole accumulated gain becomes taxable in that year and can push them into a much higher bracket. A spouse can also choose to be treated like a non-spousal beneficiary and use one of the options below, but electing that permanently gives up continuation.

If You’re Not the Spouse

Children, grandchildren, siblings, and other individual beneficiaries can’t continue the contract. Federal law requires the entire interest to be distributed within five years of the owner’s death unless you qualify for and elect the life-expectancy option.⁴ If you make no election, the five-year rule is what applies by default.

The Five-Year Rule

Everything has to be paid out by December 31 of the fifth year after the owner’s death. There’s no schedule inside that window. You can drain the account in year one, spread withdrawals across all five years, or wait until the last year and cash out. The gain-first ordering still applies to each withdrawal, so if the contract holds $200,000 of gain and $150,000 of basis, the first $200,000 you pull is fully taxable. Spreading withdrawals across multiple tax years can keep more of that gain in lower brackets.²

The Life-Expectancy Stretch

The alternative is to annuitize the contract over your own life expectancy. Two conditions have to be met: the contract itself has to permit it, and distributions have to begin no later than one year after the original owner’s death.⁴ Miss that one-year window and you’re locked into the five-year rule.

Because you’ve annuitized, each payment is split using the exclusion ratio. Cost basis divided by total expected payments over your life expectancy (from the IRS actuarial tables) gives the tax-free fraction of each payment. The life expectancy is fixed at your age in the year following the owner’s death and doesn’t recalculate. A younger beneficiary gets a longer stretch, smaller annual payments, and a smaller annual tax bill. It’s worth running the numbers before defaulting to the five-year rule because it looks simpler.

If a Trust Is the Beneficiary

Naming a trust changes the picture. The statute defines a designated beneficiary eligible for the stretch as “any individual designated a beneficiary by the holder.”⁴ A trust isn’t an individual, so the stretch is generally off the table and the trust is stuck with the five-year rule.

The rate problem is worse than the timeline. Trusts hit the top 37% federal bracket at just $16,001 of taxable income in 2026, versus roughly $626,350 for a single individual. Gain flowing through a trust and retained there can hit the highest rate almost immediately. If the trust distributes the income to its beneficiaries, they report it at their own (usually lower) rates, but accumulation inside the trust is expensive. If your estate plan routes an annuity through a trust, that’s a conversation to have with a tax advisor before the owner dies.

The 10% Early Withdrawal Penalty Doesn’t Apply

Distributions from a non-qualified annuity before age 59½ normally carry a 10% penalty on top of income tax. Inherited annuities are exempt. Federal law waives the penalty for any distribution to a beneficiary after the holder’s death, regardless of the beneficiary’s age.⁶ A 35-year-old who inherits and cashes out owes income tax on the gain, but no penalty.

The 3.8% Net Investment Income Tax

Higher-income beneficiaries face an additional layer. The 3.8% Net Investment Income Tax applies to non-qualified annuity distributions when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married filing jointly.⁷ Those thresholds aren’t indexed for inflation, and a large distribution can push you across them, stacking the 3.8% surtax on top of your regular income tax. It’s another argument for spreading distributions across years when the payout option allows it.

Estate Tax and the IRD Deduction

The full value of a non-qualified annuity payable to a beneficiary is included in the deceased owner’s gross estate for federal estate tax purposes.⁸ For 2026 the federal exemption is $15,000,000 per person, so most estates owe no federal estate tax at all.⁹

When an estate is large enough to owe estate tax, the same annuity gain gets hit twice: once as part of the taxable estate and again as ordinary income to you when you take distributions. Congress provided partial relief through the income in respect of a decedent (IRD) deduction, which lets you deduct on your personal income tax return the portion of federal estate tax attributable to the annuity’s gain.¹⁰ It doesn’t eliminate the double tax, and calculating the exact amount usually means working with a tax professional.

What You’ll Get and What Gets Withheld

The insurance company reports every distribution on Form 1099-R in your name and tax ID.¹¹ The form shows the gross distribution and the taxable amount separately; the difference is your tax-free basis. You report the taxable portion as ordinary income on your Form 1040.

Withholding is on by default. For non-periodic payments like a lump sum or an irregular withdrawal under the five-year rule, the default federal rate is 10% of the taxable amount, and you can adjust or waive it with Form W-4R.¹² For periodic annuity payments, withholding runs like wage withholding based on your W-4P.¹³

The 10% default often falls short of the actual tax owed, especially in higher brackets or when the 3.8% NIIT applies. If the gap is large, the IRS expects quarterly estimated payments using Form 1040-ES to avoid underpayment penalties. State income tax withholding varies by where you live, and some states impose no income tax at all.

1
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
2
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
3
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
4
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
5
Internal Revenue Service. Part I Section 1035 – Certain Exchanges of Insurance Policies
6
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
7
Internal Revenue Service. Net Investment Income Tax
8
Office of the Law Revision Counsel. 26 USC 2039 – Annuities
9
Internal Revenue Service. Whats New – Estate and Gift Tax
10
Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents
11
Internal Revenue Service. Instructions for Forms 1099-R and 5498 (2025)
12
Internal Revenue Service. 2026 Form W-4R
13
Internal Revenue Service. Topic No. 410, Pensions and Annuities