Are Inherited Annuities Taxable? Payouts, Penalties, and Reporting

Yes, inherited annuities are taxable, and most of what you receive counts as ordinary income on your federal return. How much of each dollar is taxable depends on two things: whether the original owner funded the annuity with pre-tax or after-tax money, and how you choose to take the money out. A large distribution in a single year can push you into a higher bracket, since 2026 federal rates run from 10% to 37%.¹

Qualified or Non-Qualified: The Split That Decides What You Owe

A qualified annuity is one held inside a tax-advantaged retirement account, such as a traditional IRA or 401(k). The original owner never paid income tax on the money that went in, so the IRS collects on the entire balance when it comes out. Every dollar of a distribution from an inherited qualified annuity is taxable as ordinary income.

A non-qualified annuity was bought with after-tax money. The owner already paid income tax on what they invested, so only the growth is taxed when you take a distribution. The original amount invested (the “cost basis” or “investment in the contract”) comes back to you tax-free.²

If the original owner put $100,000 into a non-qualified annuity and the contract was worth $150,000 when you inherited it, only $50,000 is subject to federal income tax. The insurance company tracks the basis and reports the taxable share to you and the IRS.

How the Taxable Portion of a Non-Qualified Annuity Is Calculated

The method depends on how you take the money.

Annuitized Payments: The Exclusion Ratio

If you take the non-qualified inherited annuity as a stream of periodic payments, the IRS uses an “exclusion ratio” to split each check between tax-free principal and taxable growth. The ratio is the investment in the contract divided by the expected total return over the payment period, and it stays the same for every payment.²

If the investment was $100,000 and the expected return is $200,000, the ratio is 50%. Half of each payment is a tax-free return of principal; the other half is taxable income.³ Once you have recovered the full original investment tax-free, every additional dollar is fully taxable.

Lump Sums and Partial Withdrawals: Earnings First

The exclusion ratio only applies to annuitized payments. If you take a lump sum or partial withdrawal before annuitizing, the IRS treats the growth as coming out first. Any distribution before the annuity starting date is allocated to income on the contract before any portion is treated as a tax-free return of principal.⁴

Say the contract has $100,000 in original contributions and $50,000 in growth. If you withdraw $50,000 in one year, all of it is taxable. You only start recovering tax-free principal after the entire $50,000 of gain has been distributed.

A full surrender works the same way: all growth is taxable, and the basis comes back tax-free.⁵ The taxable amount is calculated on the cash value without subtracting any surrender charge, so you can owe tax on money the insurer kept as a fee.

Your Payout Choices Change the Yearly Tax Bill

The distribution option you pick controls how the taxable income is spread across years.

Lump Sum

Taking everything at once gives you immediate access but concentrates all the taxable income into one calendar year. For a large annuity, this can push you into a much higher bracket than staggered payments would.

Five-Year Rule

You have until December 31 of the fifth year after the owner’s death to empty the account. No annual withdrawals are required during that window; you decide when to take the money.⁶ Spreading distributions across several tax years can keep you in a lower bracket than a lump sum would. Funds remaining after the deadline can trigger penalties.

10-Year Rule

If you inherited a qualified annuity from someone who died in 2020 or later and you are not an “eligible designated beneficiary,” you must withdraw the entire balance by December 31 of the year containing the 10th anniversary of the owner’s death.⁷ If the owner died before the age when required minimum distributions would have started, no annual withdrawals are required within the 10 years; you just have to empty the account by the deadline.⁸

Eligible designated beneficiaries are exempt from the 10-year rule and can stretch distributions over their own life expectancy:

A surviving spouse.
A minor child of the deceased owner, who can take life-expectancy distributions until reaching the age of majority; the 10-year clock then starts.
A disabled or chronically ill individual, who can use life-expectancy distributions indefinitely.
A beneficiary no more than 10 years younger than the deceased owner.

Adult children, siblings, friends, and most trusts fall outside these categories and are bound by the 10-year rule.⁶

Life-Expectancy Payments

Converting the death benefit into a stream of payments over your life expectancy spreads the tax across the longest period. For non-qualified annuities, the exclusion ratio applies, so part of each payment is tax-free. For qualified annuities, each payment is fully taxable, but the smaller annual amounts help keep you in a lower bracket. Payment amounts depend on your age and IRS actuarial tables.⁹

Extra Options for a Surviving Spouse

A surviving spouse who inherits a qualified annuity has choices no other beneficiary gets. The most valuable is rolling the annuity into their own IRA or qualified plan. The money is then treated as if it had always belonged to them, and distributions can be delayed until their own required beginning date, currently age 73.¹⁰ That can add years of tax-deferred growth.

A surviving spouse can also keep the annuity as an inherited account and delay distributions until the year the deceased would have turned 73, or elect life-expectancy payments to stretch the taxable income over many years.⁵

For non-qualified annuities, some insurers allow “spousal continuation,” which lets the surviving spouse take over the contract in their own name and keep the tax deferral going. Options depend on the specific contract, so the insurance company is the right first call.

No Step-Up in Basis

Unlike stocks or real estate, an inherited annuity does not get a step-up in basis at the owner’s death. Federal law specifically excludes annuities from that general rule.¹¹ The full accumulated growth passes to you as taxable income. If the owner invested $50,000 and the contract grew to $125,000, your basis stays at $50,000 and the $75,000 gain will be taxed as ordinary income when distributed. Keeping the original purchase records helps you prove the correct basis.

No 10% Early Withdrawal Penalty for Beneficiaries

The 10% early withdrawal penalty that applies to the original owner does not apply to you. Federal law exempts distributions made after the death of the plan participant or IRA owner from the 10% additional tax, whatever the beneficiary’s age.¹²

Penalties for Missing a Required Distribution

If you are required to take distributions from an inherited qualified annuity under the 10-year, five-year, or life-expectancy rules and you fall short in a given year, the IRS imposes a 25% excise tax on the shortfall. Correcting the missed amount within the designated correction window drops the penalty to 10%.⁸

Estate Tax and the IRD Deduction

An inherited annuity is included in the deceased person’s gross estate for federal estate tax purposes.¹³ For 2026, the federal estate tax exemption is approximately $15 million per person ($30 million per married couple), and the top rate is 40%. Most estates fall well below that threshold, but larger estates can face both estate tax and income tax on the same annuity.

To ease that double hit, federal law provides the Income in Respect of a Decedent (IRD) deduction. If estate tax was paid on the annuity’s value, you can deduct a portion of that estate tax from your own taxable income when you report the annuity distributions.¹⁴ The deduction is calculated based on the share of the total estate tax attributable to the annuity.¹⁵ Some states also impose their own estate or inheritance taxes with lower thresholds, which can add a state-level bill on top.

Reporting the Distribution on Your Tax Return

The insurance company or plan administrator sends you Form 1099-R for any year you receive a distribution. Box 7 carries the distribution code; inherited annuity payments use Code 4, which identifies the payment as going to a beneficiary after the owner’s death.¹⁶

Box 1 shows the gross distribution and Box 2a shows the taxable amount. For a qualified annuity, the two numbers usually match because the whole distribution is taxable. For a non-qualified annuity, Box 2a reflects only the gain. Report those amounts on your federal return, and if estate tax was paid on the annuity, apply the IRD deduction to reduce the taxable portion.

1
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
2
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
3
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
4
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
5
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
6
Internal Revenue Service. Retirement Topics – Beneficiary
7
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
8
Internal Revenue Service. Publication 590-B (2025), Distributions From Individual Retirement Arrangements (IRAs)
9
Internal Revenue Service. Actuarial Tables
10
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
11
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
12
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
13
Office of the Law Revision Counsel. 26 U.S. Code 2039 – Annuities
14
Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents
15
eCFR. 26 CFR 1.691(c)-1 – Deduction for Estate Tax Attributable to Income in Respect of a Decedent
16
Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498