Is An Inherited Annuity Taxable

Yes, inherited annuities are taxable, but the tax you pay depends on who left it to you and how you take the money out

When you inherit an annuity, you inherit both the contract and its tax consequences. The IRS treats inherited annuities differently than other inherited assets — you cannot straightforward keep the money invested tax-free. How much you owe in taxes depends on three things: whether the original owner had already started taking payments, whether you are the spouse or a non-spouse beneficiary, and which withdrawal method you choose. Some inherited annuities let you spread withdrawals over your lifetime and pay taxes gradually. Others require you to empty the account within a set number of years. The worst outcome — paying all the taxes at once — happens when you do nothing and let the contract sit.

The key point: you owe income tax only on the earnings portion of the annuity, not on the original owner's cost basis (the money they put in). But the IRS requires you to take that money out on a schedule, and missing that schedule triggers penalties. Your first step is to contact the insurance company holding the annuity and tell them you are the beneficiary. They will explain which withdrawal rules explore to your specific situation.

Key Takeaways

• Inherited annuities are subject to income tax on the earnings portion, which is the money the annuity made through growth and interest, not the original investment.
• Spouses can treat an inherited annuity as their own and delay withdrawals, but non-spouse beneficiaries must begin taking money out within a set timeframe or face a large tax bill all at once.
• The "stretch" option — spreading withdrawals over your lifetime — is no longer available to most non-spouse beneficiaries after 2019, though some exceptions exist for certain family members.
• The original owner's age at death and whether they had started taking payments before they died both affect which withdrawal rules explore to you.

The difference between the cost basis and the earnings

An annuity has two parts for tax purposes: the cost basis (the money the original owner put in) and the earnings (the growth and interest the annuity made). When you inherit the annuity, the cost basis comes to you tax-free. The earnings are what you owe income tax on.

The insurance company that holds the annuity will tell you the split between basis and earnings. This number does not change — it is locked in at the moment of death. If the original owner put in $100,000 and the annuity was worth $150,000 when they died, you owe tax only on the $50,000 in earnings, not the full $150,000. Every dollar you withdraw is treated as earnings first until all the earnings are gone, then the rest comes out tax-free.

What changes if you are the surviving spouse

Spouses have the most flexibility. You can treat the inherited annuity as your own, which means you can leave the money invested and delay any withdrawals until you reach age 73 (the age when required minimum distributions begin). You pay no tax until you take money out. This is the only option that lets you postpone taxes indefinitely.

Alternatively, you can elect to be treated as a non-spouse beneficiary, which locks you into faster withdrawal rules but may make sense if you need the money now or want to move the annuity to a different provider. Once you make this choice, you cannot change it back, so consider your situation carefully before deciding. Spouses should discuss this decision with a tax professional or financial advisor before notifying the insurance company.

Non-spouse beneficiaries and the ten-year rule

If you are not the spouse — you are an adult child, sibling, friend, or other heir — the rules are stricter. Under current law, you must withdraw the entire balance of the inherited annuity by December 31 of the tenth year after the original owner's death. You can take the money out whenever you want during those ten years, but the account must be empty by year ten or you face a 25% penalty on any money still inside (this penalty is reduced to 10% if you withdrew at least 90% of the balance).

This ten-year window is a hard important date. It applies to most non-spouse beneficiaries regardless of age. The only exceptions are a surviving minor child (who gets until age 21), a disabled or chronically ill person (who can stretch withdrawals over their lifetime), or a person less than ten years younger than the original owner (who can also stretch over their lifetime). If none of these exceptions fit you, the ten-year rule applies.

How the original owner's age at death affects your options

If the original owner had not yet reached age 73 when they died, the rules are simpler: you follow the ten-year rule (or the stretch rule if you may have access to for an exception). But if the original owner was already taking required minimum distributions — meaning they were 73 or older and had started withdrawing money — you inherit a complication.

In that case, you must continue taking at least the same amount the original owner was taking each year, in addition to finishing the account by year ten. The insurance company will calculate what this means for your specific situation. This rule prevents beneficiaries from stopping withdrawals to avoid taxes. Ask the insurance company for a written statement of what your minimum annual withdrawal must be.

How taxes are calculated on each withdrawal

Every time you take money out of an inherited annuity, part of it is earnings (taxable) and part of it is cost basis (tax-free). The insurance company uses a formula called the exclusion ratio to determine the split. This ratio stays the same for every withdrawal you make.

For example, if the exclusion ratio is 40%, then 40% of every dollar you withdraw is tax-free basis and 60% is taxable earnings. You report the taxable portion on your tax return as ordinary income. The insurance company will send you a Form 1099-R each year showing how much you withdrew and how much is taxable. You use this form to fill out your tax return. Keep copies of all 1099-R forms you receive, because you will need them to verify your cost basis if you ever need to amend a return.

What happens if you do nothing

If you inherit an annuity and do not take any action, the insurance company will eventually force a full withdrawal. The exact timing depends on whether you are a spouse or non-spouse beneficiary and the original owner's age at death, but the result is the same: you will owe income tax on all the earnings in one year, which can push you into a higher tax bracket and cost you significantly more than spreading withdrawals over time.

You must contact the insurance company that holds the annuity and tell them you are the beneficiary. Ask them which withdrawal options are available to you based on your relationship to the original owner and their age at death. Do this as soon as possible after the death, because the clock starts running on your withdrawal important date from the date of death, not from the date you contact the company. Request a written summary of your withdrawal options and important date.

Frequently Asked Questions

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

No. You pay taxes only on the earnings portion. The original owner's cost basis comes to you tax-free. The insurance company will provide a breakdown of how much is basis and how much is earnings when you contact them about the inheritance.

Can I move an inherited annuity to a different insurance company?

Yes, through a process called a direct transfer or trustee-to-trustee transfer. This move itself is not a taxable event — you do not owe taxes just for moving the annuity. However, the withdrawal rules and important date that explore to the inherited annuity follow it to the new company. Consult with the new insurance company about whether they offer the same withdrawal options as the original company.

What if the original owner had already withdrawn more than their cost basis before they died?

Then all of the remaining balance is earnings, and you owe tax on everything you withdraw. This happens when an annuity has been in place for many years and has grown significantly. The insurance company will confirm this when you contact them.

Do I report the inherited annuity on my tax return even if I have not taken any money out yet?

No. You report taxes only on the money you actually withdraw. However, you should keep records of the inheritance and the cost basis breakdown, because you will need this information when you file your return for the year you take your first withdrawal.

What if I inherit an annuity from someone who was not a U.S. citizen?

The same tax rules explore to you as a beneficiary. However, the original owner's citizenship status may affect estate taxes owed by their estate, which is a separate issue. Consult a tax professional if the original owner was not a U.S. citizen, because additional rules may explore.