Inherited Annuity Taxation: Can You Minimize the Tax Burden?

Understanding your options is key to managing taxes on inherited annuities.

Key takeaways:

• Inherited annuities come with tax implications that beneficiaries should plan for.
• Distribution options like lump-sum, five-year rule, or annuitization affect your tax burden.
• The 1035 exchange can help defer taxes by transferring the annuity to a new one.
• Consulting a financial advisor can help you make informed decisions that may help to minimize taxes and maximize value.

If you are on the receiving end of an inherited annuity, it could turn out to be a double-edged sword. While an inherited annuity can provide an unexpected windfall, the tax implications of withdrawing money from it could be costly.

Let’s be clear: inherited annuity taxation is unavoidable. You can’t completely eliminate taxes. There will be some inherited annuity taxes. However, you may be able to significantly reduce your tax burden in many situations.

Learning about your options related to taxes and inherited annuities can help you keep more of the funds from that asset. Let’s take a closer look at how annuities are structured, as well as your options for receiving the benefits of an inherited annuity.

What is an Inherited Annuity?

At its core, an annuity is a contract between an individual and a life insurance company.

In return for a lump sum of money provided by the individual (or a series of payments), the insurer contractually commits a specific amount of fixed, periodic payments. These payments may extend over the annuitant’s lifetime or last for a specific period of time (i.e., ten years) defined in the contract.

Annuity payments consist of a return of principal — the money the annuitant pays into the contract — and interest earned inside the contract. The interest portion is taxed as ordinary income, while the principal amount is not taxed. For annuities paying out over a more extended period or life expectancy, the principal portion is smaller, resulting in fewer taxes on the monthly payments.

A common question: If I inherit an annuity, is it taxable? The answer depends on whether you’re inheriting the principal or earnings portion of the contract.

People decide to buy annuities for a few reasons. The guaranteed payments are the primary motivation for more people.

The tax benefits we just reviewed are also important. The ability to designate a beneficiary and have the payments continue in the event of the purchaser’s death is another reason people choose annuities.

When someone purchases an annuity, they can name one or more beneficiaries. These named individuals become eligible to receive the payments if the annuitant — the person who took out the annuity — dies.

For a married couple, the annuity contract may be structured as a joint and survivor. That means if one spouse dies, the survivor may continue to receive contractually scheduled payments and enjoy the same tax deferral.

Spousal beneficiaries generally have more distribution options available to them than non-spouse beneficiaries when inheriting annuities. Beyond joint and survivor arrangements, surviving spouses can often take ownership of the contract and continue it as their own, maintaining the original tax-deferred status.

A surviving spouse may delay beginning distributions, take distributions based on their own life expectancy, or follow alternative distribution rules not available to non-spouse beneficiaries. Spousal continuation is often the most tax-efficient choice because it preserves the annuity’s tax-deferred growth.

If a beneficiary is named, such as the couple’s child, they become the recipient of an inherited annuity. As the beneficiary, they can choose from four distribution options that produce four different tax consequences.

Distribution Options from an Inherited Annuity

Beneficiaries have multiple options to consider when choosing how to receive money from an inherited annuity. Each choice comes with different annuity inheritance tax consequences. The best choice for any individual should depend on their tax situation and financial plan.

Lump-Sum Distribution

The money from an inherited annuity can be paid out as a single lump sum, which becomes taxable in the year it is received. If the annuity was held in a retirement account, the entire amount is taxable at your marginal income tax rate.

If the annuity was held in a non-qualified account (non-retirement account), then only the earnings are taxable at your marginal income tax rate. This can lead to a significant tax burden, although it also offers flexibility and immediate access to the after-tax funds from the annuity.

Five-Year Rule

For non-qualified annuities, payments can be spread out over five years, spreading out the tax burden. However, most non-spouse beneficiaries who inherit qualified annuities (those held in IRAs or other retirement accounts) must now follow the SECURE Act’s 10-year distribution rule, requiring the entire balance to be withdrawn within 10 years of the original owner’s death.

The tax-free principal is not paid out until after the earnings are paid out. That means the inherited annuity taxes will drop off once the earnings are exhausted and the tax-free principal becomes the source of the payments.

Annuitization

The beneficiary can request that the proceeds be annuitized. This option turns the money into a stream of income, either for a lifetime or a set period of time. It provides a consistent, scheduled stream of income, which may suit beneficiaries who prioritize predictable cash flow. ¹

The downside to annuitization is that it is irrevocable. That means you can’t have access to the money except through monthly payments. That’s true even if your financial circumstances change and the total amount of funds is needed.

The upside is that the payments are only partially taxed on the interest portion, which means you can defer taxes well into the future. Depending on your tax position and overall financial situation, this option may help reduce some of the taxes on an inherited annuity.

Nonqualified Stretch

Also referred to as the Life Expectancy or One-Year Rule, the nonqualified stretch option uses the beneficiary’s remaining life expectancy to calculate an annual required minimum distribution.

Beneficiaries must typically make their payout election within one year of the annuity owner’s death to preserve the stretch option. Failure to elect within the insurer’s specified timeframe may eliminate this option entirely, forcing a faster distribution schedule and higher taxes.

Nonqualified means that the inherited annuity did not originate inside a qualified retirement plan, such as an IRA. The stretch option offers more flexibility in how and when you can access money from an inherited annuity while helping to extend its tax deferral.

While the question ‘how do I avoid taxes on an annuity death benefit?‘ has no complete answer, the stretch option may help reduce the tax burden by spreading distributions over your lifetime.

As of 2026, the Required Minimum Distribution (RMD) age is 73. If an annuity owner dies after they have already started taking RMDs, beneficiaries must continue taking those annual distributions

Beneficiaries determine their initial life expectancy using the IRS Single Life Table. Each year, one year is subtracted from the initial life expectancy factor to determine the required minimum distribution for that year.

For example, if the initial life expectancy factor is 30 years, the amount of capital available for distribution is divided by 30 to determine the minimum payout for that year. The following year, the remaining amount of money is divided by 29, and so on.

If there are multiple beneficiaries, each one can use their own life expectancy to calculate minimum distributions.

With the stretch option, beneficiaries are not limited to taking the minimum distribution. They can take as much as they want, up to the entire remaining capital. Beneficiaries are required to take at least the minimum distribution each year, regardless of personal preference.

Beneficiaries can name a successor beneficiary who can finish taking the required minimum distributions if the beneficiary dies. However, the successor beneficiary must base minimum distribution amounts on the life expectancy of the first beneficiary.

If an account owner fails to withdraw the full amount of the RMD by the due date, the amount not withdrawn may be subject to an excise tax of 25%, 10% if the RMD is timely corrected within two years.

Which Annuity Distribution Option is Right for Me?

Choosing your annuity distribution option can have a significant impact on your overall tax burden. Consulting with a fiduciary financial advisor — a professional legally obligated to act in your best interests- can help you better understand your options.

Below is a brief overview of the annuity tax implications of each distribution option and how they influence your finances.

Of the four options, annuitization and the nonqualified stretch may be appropriate if spreading the tax burden over a longer period is the priority. These options may do the most to reduce near-term inherited annuity taxes, though some tax liability will apply in virtually all cases.

If you are most concerned about getting more money in your hands more quickly, the lump sum or five-year rule options may be appropriate. Keep in mind that you will incur a larger and more immediate tax liability if you select the lump-sum or five-year rule distribution options.

A financial professional can help you evaluate your options and determine the best strategy for you.

1035 Exchange Option

If you don’t have an immediate need for the cash from an inherited annuity, you could choose to roll it into another annuity you control. A 1035 exchange allows for the tax-free transfer of an annuity contract for another annuity contract, as provided under Section 1035 of the Internal Revenue Code. The exchange must be a direct transfer between insurance companies, and the same person must own both the old and new contracts

Through a 1035 exchange, you can direct the life insurer to transfer the cash from your inherited annuity into a new annuity you establish. That way, you continue to defer taxes until you access the funds, either through withdrawals or annuitization.

If your inherited annuity is non-qualified (established outside a qualified retirement plan), it can be exchanged for another non-qualified annuity via a 1035 exchange. However, annuities held inside IRAs or other qualified retirement plans cannot use a 1035 exchange. They follow different tax rules and would instead require a direct IRA-to-IRA transfer.

Inheriting an annuity can be a financial boon.

While annuity inheritance tax cannot be eliminated, there are distribution strategies that may help reduce the current tax burden and extend tax deferral, which may support the long-term value of the annuity.

Annuities can be somewhat complex instruments, and their taxation is even more difficult to understand. Consulting with a qualified financial advisor before making any distribution decisions is an important step in managing taxes on an inherited annuity.

Discuss Your Inherited Annuity with a Financial Advisor

• The guarantees and benefits provided are subject to the claims paying ability of the issuing insurance company. Most states protect annuity owners up to $250,000 per person, per company through state Insurance Guarantee Associations, though coverage limits and terms vary by state. Insurance companies are required to maintain reserves against their obligations.↩︎