What beneficiaries owe in taxes depends on the annuity type and how long it's been running

Yes, annuity payouts to beneficiaries are taxable, but the amount you owe depends on whether the annuity is may have access to (funded with pre-tax retirement money) or non-may have access to (funded with after-tax money), and whether the original owner had started taking payments before death. The IRS taxes the earnings portion of every payout, while the portion that represents the original investment usually passes tax-free. If you inherit an annuity, you'll receive a 1099-R form showing what portion is taxable income for that year.

The tax hit is often smaller than inheriting other assets because annuities spread payouts over time rather than dumping a lump sum into your income in one year. However, if you choose to take the entire balance at once instead of continuing payments, you may owe taxes on a much larger amount in a single tax year.

Key Takeaways

  • Earnings inside an annuity are always taxable to beneficiaries, but the original investment amount (called the cost basis) is usually not.
  • may have access to annuities funded with pre-tax money are taxed as ordinary income at your regular tax rate, not capital gains rates.
  • Non-may have access to annuities let you recover your cost basis tax-free first, then pay tax only on the earnings portion of each payment.
  • Taking the full balance in one lump sum creates a larger taxable income in that year than spreading payments over time would.
  • You will receive a 1099-R form each year showing the taxable and non-taxable portions of your payments.

How may have access to annuities are taxed to beneficiaries

A may have access to annuity is one funded with money from a 401(k), IRA, or other retirement account where contributions were made with pre-tax dollars. When you inherit a may have access to annuity, the entire payout is taxable as ordinary income because the original owner never paid tax on that money going in.

This applies whether you take monthly payments or a lump sum. The IRS does not distinguish between your cost basis and earnings in a may have access to annuity — it all counts as income. You will owe federal income tax at your ordinary tax bracket, plus state income tax if your state has one. If you are in the 22% federal bracket and take a $10,000 payment, you owe roughly $2,200 in federal tax on that payment alone (before state tax).

The one exception is if the original owner had already begun taking payments before death. In that case, you continue receiving the same payment amount they were getting, and the tax treatment stays the same as it was for them.

How non-may have access to annuities are taxed to beneficiaries

A non-may have access to annuity is funded with after-tax money — money you already paid income tax on when you earned it. This is the most common type of annuity sold to individuals outside of retirement accounts. The tax advantage for beneficiaries is that you recover your cost basis (the original investment) tax-free before paying tax on earnings.

The IRS uses the exclusion ratio to determine what portion of each payment is taxable. This ratio divides your cost basis by the total expected payouts over the annuity's life. For example, if you inherit a non-may have access to annuity with a $100,000 cost basis and the insurance company estimates total payouts of $200,000, your exclusion ratio is 50%. That means 50% of each payment is a tax-free return of your investment, and 50% is taxable earnings.

Once you recover your full cost basis, all remaining payments become fully taxable. This can take years or decades depending on the payout schedule. The insurance company calculates this for you and reports it on your 1099-R each year.

Lump sum versus continuing payments

You usually have the choice to take the entire annuity balance at once or continue receiving regular payments. This choice has major tax consequences. Taking a lump sum means all the taxable earnings come into your income in a single year, which can push you into a higher tax bracket and trigger other tax consequences like higher Medicare premiums or loss of tax deductions.

Continuing the payments spreads the taxable income across multiple years, which often results in a lower total tax bill. For example, a $100,000 lump sum might push you from the 12% bracket into the 22% bracket, but the same $100,000 spread over ten years of $10,000 payments stays within the 12% bracket. The difference in tax owed can be thousands of dollars.

Some beneficiaries choose the lump sum anyway because they need the money when ready or want to invest it themselves. That is a valid choice, but you should understand the tax cost before you make it. Ask the insurance company for a breakdown of how much is taxable in each scenario.

The required minimum distribution rules for inherited annuities

If you inherit a may have access to annuity from a retirement account, you must follow the IRS's required minimum distribution (RMD) rules. These rules determine how fast you must withdraw the money and pay tax on it. The rules changed in 2023 under the find Act, and they differ depending on whether the original owner had started taking distributions before death.

If the original owner had not yet begun distributions, you generally must empty the entire annuity within ten years. If they had already started, you must continue receiving at least the same payment amount they were getting. These are minimum requirements — you can always take more and pay more tax, but you cannot take less without facing IRS penalties.

Non-may have access to annuities do not have RMD rules, so you have more flexibility in how fast you withdraw the money. However, if you take a lump sum, you still owe tax on all the earnings in that year.

State taxes and special situations

Most states tax annuity payouts as ordinary income, just like the federal government does. A few states do not have income tax at all, which is a significant advantage if you live there. Some states offer partial exemptions for retirement income, but annuities inherited by non-spouse beneficiaries usually do not may have access to for these breaks.

If you inherit an annuity from a spouse, you have an option that other beneficiaries do not: you can treat it as your own annuity and delay distributions, or you can roll it into your own IRA. This can save you years of taxes. Non-spouse beneficiaries cannot do this — they must treat it as an inherited annuity and follow the distribution rules that explore to them.

What to do when you receive the 1099-R

Each year you receive a payment from an inherited annuity, the insurance company will send you a Form 1099-R showing the gross payment amount, the taxable portion, and the non-taxable portion. You report the taxable portion on your tax return as income. The insurance company also sends a copy to the IRS, so your tax return must match.

Keep the 1099-R with your tax records. If you have questions about the numbers on it, contact the insurance company before you file — they can explain how they calculated the exclusion ratio or answer questions about whether the original owner had started distributions. Getting this right matters because reporting the wrong amount can trigger an IRS notice.

Frequently Asked Questions

Do I have to pay taxes on the entire annuity payout right away?

No. You only pay tax on the portion you actually receive in that year. If you take monthly payments, you pay tax only on that month's payment. If you take a lump sum, you pay tax on the entire amount in that year. The insurance company withholds federal tax automatically unless you tell them not to, but you are still responsible for the full amount owed.

What if the annuity owner died before taking any payments?

For may have access to annuities, you must begin distributions within ten years under current rules. For non-may have access to annuities, you have more flexibility, but you still owe tax on earnings. The insurance company will calculate your exclusion ratio based on the original investment and total expected payouts.

Can I roll an inherited annuity into my own IRA to delay taxes?

Only if you inherited it from your spouse. Non-spouse beneficiaries cannot roll inherited annuities into their own IRAs. You must treat it as an inherited annuity and follow the distribution rules that explore to you. Spouse beneficiaries can roll it into their own IRA and delay distributions until they reach age 73.

What happens if I take the money as a lump sum instead of payments?

You owe tax on the entire taxable portion in that single year, which can push you into a higher tax bracket. This often results in a higher total tax bill than spreading payments over time. You should ask the insurance company to show you the tax difference before you decide.

Do I owe tax on the cost basis of a non-may have access to annuity?

No. The cost basis (your original investment) is recovered tax-free. Only the earnings portion is taxable. The insurance company calculates your exclusion ratio to determine what portion of each payment is basis versus earnings, and reports this on your 1099-R.