Annuity death benefits are taxable income to the person who receives them, but the tax treatment depends on what kind of annuity it was and how much of the payout is earnings versus your original investment.
When you own an annuity and die, the money that goes to your beneficiary is not automatically tax-free just because it came from a death benefit. The IRS taxes the earnings portion — the money the annuity earned over time — as ordinary income. Your original investment (called the cost basis) comes out tax-free. The split between the two determines how much your beneficiary actually owes.
The exact tax bill depends on three things: whether the annuity was may have access to (held in a retirement account like an IRA) or non-may have access to (held outside retirement accounts), whether you had started taking payments before you died, and how much of the payout is growth versus your money.
Key Takeaways
- The earnings portion of an annuity death benefit is taxable as ordinary income to your beneficiary, while your original investment comes out tax-free.
- Non-may have access to annuities allow your beneficiary to spread the tax bill over their life expectancy if they take payments instead of a lump sum.
- may have access to annuities (in IRAs or 401(k)s) have different rules and may require your beneficiary to withdraw the entire balance within ten years under current law.
- Your beneficiary will receive a Form 1099-R showing the taxable amount, which they report on their own tax return.
- If you die before starting payments, your beneficiary's tax burden is usually smaller than if you had already begun withdrawals.
How the tax split works between your money and earnings
When you buy an annuity, you pay a premium — that is your cost basis. Over time, the annuity earns interest or investment returns. When you die and your beneficiary receives the payout, the IRS separates these two parts. Your cost basis comes out tax-free. The earnings are taxed as ordinary income at your beneficiary's tax rate.
The annuity company calculates this split using an exclusion ratio. If you paid $100,000 into a non-may have access to annuity and it grew to $150,000, your cost basis is $100,000 and the earnings are $50,000. Your beneficiary would owe income tax on that $50,000. The company will report this on Form 1099-R, which your beneficiary uses to file their tax return.
This is different from life insurance death benefits, which are usually completely tax-free. Annuities are contracts that earn money over time, so the IRS treats the growth as taxable income to whoever receives it.
Non-may have access to annuities and the stretch option
If you owned a non-may have access to annuity (one you bought with after-tax money, not through a retirement plan), your beneficiary has a choice that affects their tax bill: take all the money at once, or take it over their lifetime in installments.
If your beneficiary takes a lump sum, they owe income tax on all the earnings in that single year. That can push them into a higher tax bracket. If they choose the stretch option — taking payments over their life expectancy — they spread the taxable earnings across many years, which usually means a lower tax rate each year.
The annuity company calculates the life expectancy using IRS tables. A 50-year-old beneficiary might spread payments over 35 years. Each payment includes a portion of your original investment (tax-free) and a portion of earnings (taxable). Over time, the ratio shifts — later payments include more earnings and less of your basis.
may have access to annuities in retirement accounts
If the annuity was inside an IRA, SEP-IRA, or 401(k), the rules are stricter. These are may have access to annuities, meaning the money was never taxed when you put it in. Your beneficiary will owe income tax on the entire payout because none of it is your after-tax contribution.
Under current law, most beneficiaries must withdraw the entire balance within ten years of your death. Some beneficiaries (spouses, minor children, disabled or chronically ill people) have different options, but the general rule is the ten-year window. This means your beneficiary cannot stretch payments over their lifetime the way they could with a non-may have access to annuity.
The annuity company will still issue Form 1099-R, but the entire amount (minus any non-taxable basis, which is rare in may have access to accounts) is taxable income. Your beneficiary reports this on their tax return for the year they receive it.
What happens if you died before taking payments
If you owned the annuity but had not yet started taking withdrawals (called the accumulation phase), your beneficiary's tax situation is usually simpler. They inherit the full value, and the earnings portion is taxed based on how they choose to receive the money.
With a non-may have access to annuity, they can still choose the stretch option and spread payments over their life. With a may have access to annuity, they still face the ten-year rule. But in both cases, they are not dealing with the extra complexity of annuitization — the conversion to a payment stream that you had already started.
If you had already started taking payments before you died, the situation is more complex. Your beneficiary may inherit the remaining balance under a continuation of your payment schedule, or they may have the option to change how they receive it. The tax treatment depends on the specific annuity contract and the payout option you chose.
The Form 1099-R and reporting on your beneficiary's tax return
The annuity company sends Form 1099-R to your beneficiary and to the IRS. This form shows the total amount received, the taxable portion, and the tax code that explains why it is taxable. Your beneficiary uses this form to report the income on their own tax return, usually on Form 1040 as ordinary income.
The form will show a code in box 7 that indicates the reason for the distribution. Code 4 means death of the annuitant. Your beneficiary should not ignore this form — the IRS receives a copy, and if your beneficiary does not report the income, the IRS will notice the mismatch.
If your beneficiary receives payments over multiple years, they will receive a Form 1099-R each year for the payment they received that year. Only the taxable portion of each payment is reported on the form.
State income tax on annuity death benefits
Most states tax annuity death benefits as ordinary income, just like the federal government does. A few states have no income tax at all, so beneficiaries in those states owe only federal tax. Some states offer small deductions or exemptions for certain types of retirement income, but annuity death benefits rarely may have access to.
Your beneficiary should check their state's tax rules or speak with a tax preparer who knows their state's law. State tax can add 3 to 10 percent to the federal bill, depending on where your beneficiary lives and their income level.
Frequently Asked Questions
Is the entire annuity death benefit taxable?
No. Only the earnings portion is taxable. Your original investment (cost basis) comes out tax-free. The annuity company calculates the split and reports it on Form 1099-R. Your beneficiary owes tax only on the earnings part.
Can my beneficiary avoid taxes by not taking the money right away?
Not completely, but they can reduce the tax burden. With a non-may have access to annuity, spreading payments over their lifetime usually means a lower tax rate each year than taking a lump sum. With a may have access to annuity, they must withdraw everything within ten years, so they cannot avoid the tax entirely, only spread it out.
What if my spouse is the beneficiary?
Spouses have more flexibility than other beneficiaries. A spouse can treat the annuity as their own, roll it into their own IRA, or keep it in the deceased spouse's name and take payments. Each option has different tax consequences. A spouse should speak with a tax preparer before deciding which route to take.
Do I owe taxes on the annuity death benefit if I inherit it as a minor?
Yes, but the rules may be different. Minor beneficiaries of may have access to annuities can sometimes delay the ten-year withdrawal important date until they reach age of majority. The earnings are still taxable when withdrawn. A parent or guardian should work with a tax preparer to understand the options.
What if the annuity had no earnings when the person died?
If the annuity value equals or is less than the original investment, there are no earnings to tax. Your beneficiary receives the money tax-free. This can happen if the market declined or if the annuity was relatively new. The Form 1099-R will show zero taxable amount.