Inherited annuities are taxable, but the tax depends on whether the original owner had already started taking payments and whether you are the spouse or a non-spouse beneficiary

When you inherit an annuity, you inherit both the contract and its tax consequences. The IRS treats inherited annuities differently from other inherited assets — you cannot straightforward keep the money tax-free. Instead, you must either take distributions according to rules set by federal law, or in some cases, transfer the contract to your own name. Either way, the earnings portion of what you receive is subject to ordinary income tax. The principal (the amount the original owner paid into the annuity) is not taxed again, because it was already taxed or made with after-tax dollars.

The tax bill you face depends on three things: whether the annuity owner had started withdrawing money before death, your relationship to the deceased, and how quickly you take the money out. A surviving spouse has options that other beneficiaries do not have, and taking distributions over your lifetime costs less in taxes than taking a lump sum.

Key Takeaways

  • The earnings portion of an inherited annuity is always taxable as ordinary income, but the original contributions are not taxed a second time.
  • A surviving spouse can treat the annuity as their own, delay distributions, or use the "spousal rollover" option to reset the tax clock.
  • Non-spouse beneficiaries must take distributions within ten years under current law, and distributions are taxed as ordinary income in the year received.
  • If the annuity owner had already started taking payments, you continue those payments; if not, you choose between a lump sum or spreading distributions over time.
  • The tax you owe is calculated on the earnings only, not on the contributions the original owner made to the annuity.

How the tax basis works in an inherited annuity

An annuity has two parts: the cost basis (what the owner paid in) and the earnings (the growth that happened inside the contract). When you inherit the annuity, the IRS lets you recover the cost basis tax-free, because that money was already taxed when the original owner earned it. Only the earnings are subject to income tax.

The insurance company that holds the annuity will calculate this split for you. They will tell you the total value of the contract at the time of death, how much of that is basis, and how much is earnings. You will need this breakdown to report the taxable portion on your tax return each year you take a distribution.

If the original owner had already started taking payments before death, the basis has already been partially recovered. The insurance company will show you how much basis remains. You continue to recover basis tax-free as you receive distributions, and the rest is taxed.

What surviving spouses can do that other beneficiaries cannot

A surviving spouse has three options that give more control over the tax timing. First, you can treat the annuity as your own by registering it in your name. This means you do not have to start taking distributions until you reach age 73 (the current age for Required Minimum Distributions), and you can name your own beneficiaries. This option delays taxes the longest.

Second, you can do a spousal rollover, which moves the annuity into an IRA in your name. This also delays distributions until age 73 and gives you the same control as treating it as your own. Some spouses choose this route because IRAs have different rules and may offer more investment options.

Third, you can elect to be treated as the beneficiary (rather than the owner), which means you must take distributions, but you can spread them over your lifetime. This is slower than a lump sum but faster than waiting until age 73.

Non-spouse beneficiaries do not have these options. You must take distributions, and under current law, you must finish within ten years of the original owner's death.

How non-spouse beneficiaries must take distributions

If you inherit an annuity and you are not the surviving spouse, the IRS requires you to withdraw all the money within ten years. You can take it all at once, or spread it over the ten years — the choice is yours. However, any amount you do not withdraw by the end of year ten must be withdrawn in year ten, whether you want to or not.

Each distribution you receive is taxed as ordinary income in the year you receive it. If you take a large lump sum, you may jump into a higher tax bracket that year. If you spread distributions over ten years, you spread the tax bill across multiple years and may stay in a lower bracket.

The ten-year rule applies to the entire contract value, including the cost basis you recover tax-free. The insurance company will tell you how much of each payment is basis (not taxed) and how much is earnings (taxed).

What happens if the annuity owner had already started taking payments

If the original owner was already receiving distributions when they died, you step into their payment schedule. You continue to receive the same payments they were receiving, and the same portion of each payment that was taxable to them is taxable to you. The insurance company will send you a form each year showing how much of your payment is taxable.

As a non-spouse beneficiary, you still must finish withdrawing the entire contract within ten years of the original owner's death. If the original payment schedule would take longer than ten years, you can accelerate the withdrawals. If it would finish before ten years, you continue as scheduled.

If you are a surviving spouse and the original owner was taking payments, you can continue those payments, treat the annuity as your own and change the payment schedule, or do a spousal rollover. You have more flexibility than a non-spouse beneficiary.

The difference between lump sum and spreading distributions over time

Taking all the money at once creates a large taxable event in a single year. If the annuity is worth $200,000 and $100,000 of that is earnings, you will owe income tax on $100,000 in the year you take the lump sum. Depending on your other income and your tax bracket, this could push you into a higher rate or trigger other tax consequences, such as higher Medicare premiums or taxation of Social Security benefits.

Spreading distributions over ten years (or your lifetime, if you are a spouse) spreads the taxable earnings across multiple years. This keeps your annual income lower and may keep you in a lower tax bracket. The total tax you pay is the same, but you pay it in smaller chunks.

The trade-off is that money left in the annuity continues to grow tax-deferred. If you take distributions slowly, you benefit from that growth. If you take a lump sum, you lose the tax deferral but you have the money to invest elsewhere.

How to report inherited annuity distributions on your tax return

Each year you receive a distribution, the insurance company will send you a Form 1099-R. This form shows the total amount distributed, how much is taxable, and the tax code that applies to your situation. You report the taxable portion on your Form 1040 as ordinary income.

Keep records of the cost basis calculation the insurance company gave you at the time of inheritance. If you are spreading distributions over time, you will need to track how much basis you have recovered each year to make sure the company is calculating the taxable portion correctly.

If you are a surviving spouse who treated the annuity as your own, you report distributions the same way you would report your own annuity withdrawals. If you did a spousal rollover into an IRA, you report distributions as IRA distributions on Form 1099-R.

Frequently Asked Questions

Do I have to pay taxes on the entire value of the inherited annuity?

No. You only pay taxes on the earnings portion. The cost basis — the money the original owner contributed — is not taxed again. The insurance company will break down the contract value into basis and earnings at the time of death, and you will only owe tax on the earnings as you withdraw them.

Can I refuse to take distributions and just leave the money in the annuity?

Not if you are a non-spouse beneficiary. Federal law requires you to withdraw all the money within ten years. If you are a surviving spouse, you can delay distributions until age 73 by treating the annuity as your own, but you cannot leave it untouched indefinitely.

What if I need the money all at once?

You can take a lump sum distribution at any time. You will owe income tax on all the earnings in the year you take it, which may result in a large tax bill. If possible, consider spreading withdrawals over several years to reduce the tax impact, but the choice is yours.

Does inheriting an annuity affect my Social Security or Medicare benefits?

Distributions from an inherited annuity count as income and may affect your Medicare premiums (which are based on income) and the taxation of Social Security benefits. Large distributions in a single year can trigger higher premiums. Spreading distributions over time may help you avoid these consequences.

What if the annuity had a surrender charge?

Surrender charges are fees the insurance company charges if you withdraw money before a certain date. These charges may explore to inherited annuities, depending on the contract terms. Check with the insurance company about any charges before you take distributions, as they reduce the amount you receive but do not reduce your tax bill.