Inherited annuities are taxable, but the tax you pay depends on who left it to you, what type of annuity it is, and how you choose to receive the money
When you inherit an annuity, you do not automatically owe tax on the full value. The tax rules split into two parts: the original owner's contributions (which were usually made with after-tax dollars) and the earnings that built up inside the annuity. The contributions come out tax-free. The earnings are taxable income, but you may spread that tax over years instead of paying it all at once, depending on your relationship to the person who died and the payout method you choose.
The IRS treats inherited annuities differently than other inherited assets because annuities are contracts designed to pay out over time. A house or stock passes to you with a "stepped-up basis" — meaning you inherit it at its current market value with no tax owed on the growth that happened before you inherited it. Annuities do not get that treatment. You inherit the tax liability along with the contract.
Key Takeaways
- The contributions the original owner made to the annuity come to you tax-free, but all earnings inside the annuity are taxable as ordinary income when you receive them.
- Spouses can treat an inherited annuity as their own and delay taking money out, but non-spouse beneficiaries must begin withdrawals within a set timeframe or face penalties.
- The payout method you choose — lump sum, installments, or annuitized payments — determines how quickly you owe tax on the earnings.
- If you inherit an annuity from someone other than your spouse, the IRS requires you to withdraw the entire balance within ten years of the owner's death.
How the tax splits between contributions and earnings
The person who bought the annuity paid premiums over time. Those premiums are called the cost basis. When money comes out of the annuity, the IRS treats it as contributions first, then earnings. This matters because contributions return tax-free and earnings are taxed as ordinary income at your tax bracket rate.
To find the cost basis, look at the annuity contract or ask the insurance company for a statement showing total premiums paid. Subtract that from the total value of the annuity at the time of death. The difference is the earnings that built up inside.
Example: Your parent bought an annuity with $100,000 in premiums over 20 years. When they died, the annuity was worth $180,000. The $100,000 in contributions comes out tax-free. The $80,000 in earnings is taxable income to you, spread across whatever payout schedule you choose.
Different rules for spouse beneficiaries versus everyone else
If you are the surviving spouse, you have options that other beneficiaries do not. You can treat the inherited annuity as your own, which means you can delay taking money out until you reach age 73 (the current required minimum distribution age). You can also roll it into your own IRA or annuity. This delay can significantly reduce your tax burden because the money stays inside the annuity and continues to grow tax-deferred.
If you are not the spouse — you are an adult child, grandchild, sibling, or other beneficiary — the rules are stricter. Under current law, you must withdraw the entire balance within ten years of the original owner's death. You can take the money out whenever you want during those ten years, but by the end of year ten, the account must be empty. All earnings come out as taxable income whenever you withdraw them.
This ten-year rule applies to most non-spouse beneficiaries. The exception is a designated beneficiary who is much younger than the original owner — such as a grandchild — who may have different options, but these are rare and require specific planning that should have been done before death.
Choosing a payout method and its tax consequences
When you inherit an annuity, you typically have three choices for how to take the money: a lump sum, installment payments over a set period, or an annuitized payout that lasts for life or a set number of years.
A lump sum means you take all the money at once. You owe tax on all the earnings in that year, which can push you into a higher tax bracket. If the earnings are large, this can be expensive.
An installment payout lets you spread withdrawals over the ten-year window (or longer if you are a spouse). You owe tax only on the earnings portion of each withdrawal, so the tax is spread across multiple years and may keep you in a lower bracket.
An annuitized payout converts the annuity into a stream of fixed payments, usually for life. Each payment includes a portion of contributions (tax-free) and a portion of earnings (taxable). The insurance company calculates the split based on your life expectancy. This method also spreads the tax over many years.
The ten-year rule and what happens if you miss it
If you inherit an annuity as a non-spouse beneficiary, the law requires the account to be empty by December 31 of the tenth year after the original owner's death. This is called the find Act 2.0 ten-year rule. You do not have to withdraw evenly each year — you can take nothing for nine years and then take it all in year ten — but the important date is firm.
If you do not withdraw the full balance by the important date, the IRS charges a 25 percent penalty on the amount that should have been withdrawn but was not. That penalty can be reduced to 10 percent if you correct the mistake within two years. The earnings are also still taxable as ordinary income, so you face both the penalty and the income tax.
Mark the important date on a calendar or set a reminder with your financial advisor. The important date is not flexible, and the penalty is automatic.
State income tax on inherited annuities
In addition to federal income tax, you may owe state income tax on the earnings. Most states tax annuity earnings as ordinary income at your state tax rate. A few states — including Illinois, Mississippi, and Pennsylvania — have special rules that may reduce or eliminate state tax on inherited annuities, but these rules vary and depend on your age and the type of annuity.
Check your state's tax agency website or ask a tax professional whether your state taxes inherited annuity earnings. If you live in a state with income tax and the annuity was issued in a different state, you may owe tax to both states, though you can usually claim a credit for taxes paid to another state.
What to do when you first inherit an annuity
When you learn you are the beneficiary of an annuity, contact the insurance company and ask for a beneficiary statement. This document shows the current value, the cost basis (total contributions), and the earnings. Keep this document — you will need it to calculate your taxes.
Next, decide on a payout method. You do not have to decide when ready, but you should decide before taking any money out, because the method you choose affects your tax bill. If the annuity is large or the earnings are substantial, talk to a tax professional before you withdraw anything. A few hours of information can save you hundreds or thousands in taxes.
If you are a non-spouse beneficiary, write down the important date: ten years from December 31 of the year the original owner died. Plan your withdrawals to stay within that window and to manage your tax bracket.
Frequently Asked Questions
Do I have to take the inherited annuity as a lump sum?
No. You can take installments, annuitize it, or even leave it alone for several years (as long as you empty it within ten years if you are a non-spouse beneficiary). The insurance company can explain all available payout options. Installments usually result in lower taxes because you spread the earnings over multiple years.
What if the annuity has no earnings, only contributions?
Then you owe no income tax on it. You receive the contributions tax-free. This can happen if the annuity was recently purchased or if the market value dropped. Ask the insurance company for the cost basis to confirm.
Can I roll an inherited annuity into my own IRA?
Only if you are the surviving spouse. Non-spouse beneficiaries cannot roll inherited annuities into IRAs. You must take the money out as the beneficiary of the original annuity contract, and you owe tax on the earnings as you withdraw them.
What happens if I inherit an annuity from someone who was already taking payments?
You inherit the remaining balance and the same tax rules explore. The cost basis is what the original owner paid in premiums, not what they already withdrew. You owe tax on the remaining earnings, and if you are a non-spouse beneficiary, you must withdraw the balance within ten years.
Do I report inherited annuity income on my tax return?
Yes. The earnings portion of each withdrawal is reported as ordinary income on your federal tax return. The insurance company will send you a Form 1099-R showing the gross distribution and the taxable portion. You report this on your Form 1040. If you are unsure how to report it, a tax professional can help.