When someone inherits a non-qualified annuity, federal tax law generally requires the entire balance to be paid out within five years of the original owner’s death. That default is the inherited annuity five-year rule, and it comes from Section 72(s) of the Internal Revenue Code.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts A beneficiary who acts in time can replace that five-year deadline with a longer, more tax-friendly payout, but the alternatives have their own conditions and clocks.
When the Five-Year Clock Applies
The five-year rule applies when the annuity owner dies before the annuity starting date, meaning the contract was still in its accumulation phase and had not been converted into a stream of payments. In that situation, the entire remaining interest must be distributed within five years of the date of death.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
Within that window, the beneficiary controls the timing. One large withdrawal, several smaller ones, or a single distribution on the last possible day all satisfy the rule, as long as the account balance reaches zero before the fifth anniversary of the death.
If the owner had already begun receiving payments before dying, a different rule applies. The remaining interest must be paid out at least as rapidly as the distribution method in place at the time of death.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts A beneficiary continuing a 20-year monthly payout, for example, keeps receiving at least that same pace. The insurance company cannot slow the schedule.
What Happens If the Deadline Is Missed
The consequence of blowing the deadline is harsh. The IRS treats the contract as if it were never an annuity at all, which means the tax deferral that made the product attractive disappears retroactively. Insurance companies track these deadlines and report every distribution to the IRS on Form 1099-R, so nothing about the payout is invisible to the government.2Internal Revenue Service. Instructions for Forms 1099-R and 5498
Stretching Payments Over Your Life Expectancy
A designated beneficiary, meaning a named individual rather than an entity, can replace the five-year deadline with distributions taken over their own life expectancy. Section 72(s)(2) allows this stretch if two conditions are met: the payments are structured over the beneficiary’s lifetime or a period no longer than that life expectancy, and the first payment begins within one year of the owner’s death.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
That one-year deadline is where people slip. The clock starts at the date of death, not the date the beneficiary learns about the account or files a claim. Spend 14 months sorting paperwork, and the stretch option is gone. The beneficiary defaults into the five-year rule with no way to opt back out.
For a younger beneficiary, the stretch can be worth a lot. Annual payments are calculated using life expectancy factors, so a 35-year-old spreads the balance across decades of small taxable amounts while the undistributed portion keeps growing tax-deferred inside the contract.
Annuitizing the Contract
Instead of taking discretionary withdrawals, a beneficiary can annuitize the inherited contract, converting the balance into a guaranteed payment stream. The insurance company calculates fixed or variable payments based on the account value and the beneficiary’s age, and payments can run for a set number of years or for life.
Annuitized payments come with a specific tax benefit called the exclusion ratio. Each payment is split into a taxable portion (the earnings) and a tax-free portion (the return of original investment). Under IRS Publication 939, the tax-free share of each payment equals the ratio of the original investment in the contract to the total expected return, and that percentage stays constant until the full original investment has been recovered.3Internal Revenue Service. Publication 939, General Rule for Pensions and Annuities After that, every dollar received is fully taxable.
Spousal Continuation
A surviving spouse gets an option no other beneficiary has. Under Section 72(s)(3), a surviving spouse named as the designated beneficiary is treated as the holder of the contract.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts In the eyes of the tax code, the spouse owns the annuity as though they always did.
That treatment resets the clock. No five-year deadline. No one-year requirement to start distributions. The contract keeps growing tax-deferred until the spouse takes voluntary withdrawals, annuitizes, or dies. The spouse can also name new beneficiaries and, if the contract allows, change investment allocations or add contributions. Continuation is not mandatory, though. A surviving spouse can still elect the lump sum, the five-year payout, or the life expectancy stretch if any of those fit better.
Taking a Lump Sum
A lump sum is the simplest option and usually the most expensive. The insurer liquidates the contract and sends the full balance, ending the agreement.
The earnings portion of a non-qualified annuity is taxed as ordinary income in the year received, and distributions follow a last-in, first-out order. Gains come out first and are taxed before any of the original investment is returned tax-free. On a $200,000 contract holding $120,000 in original premiums and $80,000 in gains, the first $80,000 distributed is entirely taxable. Federal ordinary income rates currently range from 10% to 37%.4Internal Revenue Service. Federal Income Tax Rates and Brackets A large single-year distribution can easily push the beneficiary into a higher bracket, so spreading distributions across multiple years almost always produces a smaller total tax bill when the rules allow it.
One consolation: inherited annuity distributions are exempt from the 10% early withdrawal penalty that normally applies to annuity withdrawals taken before age 59½. Insurers also commonly waive any remaining surrender charges when paying a death benefit, even during the surrender period.
Trusts, Estates, and Other Non-Individual Beneficiaries
When a trust, estate, charity, or other entity is named as the beneficiary of a non-qualified annuity, the life expectancy stretch is off the table. Section 72(s) reserves the stretch for a “designated beneficiary,” which means a natural person.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Entities have no life expectancy, so the five-year rule is the only available method.
This trips up estate planners more often than you would expect. An owner names a revocable trust as beneficiary for probate-avoidance reasons and unintentionally eliminates the stretch for the trust’s individual beneficiaries. Anyone holding a substantial annuity should check that the beneficiary designation matches the distribution strategy they actually want.
Qualified Annuities Follow a Different Rule
Everything above applies to non-qualified annuities, meaning contracts purchased with after-tax dollars outside a retirement plan. An annuity held inside an IRA, 401(k), or another qualified retirement account is governed by the required minimum distribution rules under Section 401(a)(9), which the SECURE Act substantially rewrote for deaths after 2019. Most non-spouse beneficiaries of a qualified annuity now must empty the account by the end of the tenth year following the owner’s death, not the fifth. Certain eligible designated beneficiaries, including surviving spouses, minor children of the account holder, disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the deceased, can still stretch over their own life expectancy.5Internal Revenue Service. Retirement Topics – Beneficiary
Distributions from a qualified inherited annuity are taxed entirely as ordinary income because the original contributions were pre-tax. With a non-qualified inherited annuity, only the earnings portion is taxable, since the original premiums were already taxed on the way in.
Making the Election on the Claim Form
The most consequential part of an inherited annuity claim is the distribution election. This is where the beneficiary picks the five-year payout, the life expectancy stretch, annuitization, a lump sum, or spousal continuation. Choose the wrong option, or leave the field blank, and the beneficiary can default into the five-year rule. Some elections are irrevocable once submitted. If the balance is substantial, a session with a tax professional before signing the form is worth the cost.