If you have inherited a non-qualified annuity, the distribution rules you need to know come from IRC Section 72(s), and they give you a different and generally more generous menu of choices than the rules that apply to inherited IRAs. A surviving spouse can take over the contract and leave it alone. Any other individual beneficiary chooses between emptying the account within five years or stretching withdrawals over their own life expectancy, as long as that stretch election is made within one year of the owner’s death. Trusts, estates, and charities get only the five-year option. Whatever path you take, the deferred gain inside the contract is taxed as ordinary income, because annuities do not get a step-up in basis at death.1Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
Why These Rules Are Not the SECURE Act Rules
A non-qualified annuity is bought with after-tax money outside any retirement plan. When the owner dies, distributions are governed by IRC Section 72(s), which explicitly carves IRAs, 401(k)s, 403(b)s, and other qualified plans out of its reach.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The SECURE Act’s 10-year rule, which reshaped inherited IRA planning in 2019, does not apply. The life-expectancy stretch that largely disappeared for retirement accounts is still available here.
The other feature that sets inherited annuities apart from inherited stock, mutual funds, or real estate is the absence of a basis step-up. IRC Section 1014(b)(9)(A) excludes annuities described in Section 72 from the stepped-up basis rule.1Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent If the original owner paid $100,000 in premiums and the contract grew to $180,000, you inherit a $100,000 cost basis and owe income tax on the $80,000 gain. Every dollar of deferred growth remains taxable eventually, no matter how long the deceased owner held the contract.
If You Are the Surviving Spouse
A surviving spouse who is the designated beneficiary gets the most favorable treatment of anyone. Under IRC Section 72(s)(3), the spouse is treated as the new holder of the contract.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts In practice, you continue the annuity as if you had always owned it. The tax deferral keeps running, no distributions are required, and the five-year clock never starts. Most insurance companies call this “spousal continuation” and handle it by re-registering the contract in your name.
Withdrawals before you reach age 59½ would still be subject to the standard 10% early withdrawal penalty under IRC 72(q), the same as for any annuity owner, but nothing forces you to take money out.3Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts When you later die, the contract passes to the next beneficiary under the standard Section 72(s) rules.
You can instead take a lump sum or use one of the non-spousal options below, but continuation is almost always the better tax move unless you need cash immediately. A lump sum forces the entire accumulated gain into one tax year and can push you into a much higher bracket.
If You Are a Non-Spouse Individual Beneficiary
Any individual beneficiary other than a surviving spouse chooses between two main paths, with a third annuitization option available on some contracts. The governing rule, IRC Section 72(s)(1)(B), says that if the holder dies before the annuity starting date, the entire interest must be distributed within five years.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts A statutory exception lets you stretch distributions over your lifetime, but only if you elect it in time.
The Five-Year Rule
Under the default rule, you must withdraw the entire account balance by December 31 of the fifth year after the owner’s death. There are no required annual minimums during that window. You can take money out in any pattern you want: small amounts each year, nothing for four years and a lump sum in year five, or anything in between. The flexibility is real, but the final deadline is firm.
The Life-Expectancy Stretch
Section 72(s)(2) waives the five-year rule if distributions begin within one year of the owner’s death and are paid over your life or life expectancy.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts You take required minimum distributions each year based on IRS life expectancy tables, and the remaining balance keeps growing tax-deferred. For a young beneficiary, that stretch can run for decades.
The one-year deadline is the detail people miss. If you do not begin life-expectancy distributions within that first year, the stretch is gone and the five-year rule takes over. Insurance companies typically present the options in writing shortly after you file the death claim, but the burden is on you to elect in time.
Annuitization
Some contracts let you convert the inherited balance into a stream of periodic payments, such as a single-life annuity or a term-certain payout that does not exceed your life expectancy. Annuitized payments use an exclusion ratio, so each payment is split into a taxable portion and a tax-free return of basis.4Internal Revenue Service. Publication 939, General Rule for Pensions and Annuities That produces a lower annual tax hit than the earnings-first rule that applies to ordinary withdrawals, but it locks the money into a fixed schedule.
One point applies to all non-spouse beneficiaries regardless of path: the 10% early withdrawal penalty does not apply to distributions after the owner’s death, at any age. IRC Section 72(q)(2)(B) specifically exempts death distributions from the penalty.3Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts A 30-year-old beneficiary owes income tax but not the extra 10% surcharge.
If the Beneficiary Is a Trust, Estate, or Charity
The life-expectancy stretch is only available to a “designated beneficiary,” which Section 72(s)(4) defines as an individual designated by the holder.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts A trust, estate, or charity is not an individual. When one of these inherits a non-qualified annuity, the five-year rule is the only option. No stretch, no life-expectancy calculation, no workaround.
This catches people off guard when an owner has named a revocable trust as beneficiary for estate-planning reasons. The trust may simplify probate, but it removes the most tax-efficient distribution method. For an annuity with a large deferred gain, naming individual beneficiaries directly on the contract often produces a better after-tax result than running the payout through a trust.
How the Distributions Are Taxed
Withdrawals and Lump Sums: Earnings Come Out First
For partial withdrawals and lump sums, IRC Section 72(e) applies what is often called the earnings-first rule. The contract’s entire accumulated gain comes out before any tax-free return of basis.5Internal Revenue Service. Publication 575, Pension and Annuity Income On a contract with $80,000 of gain over a $100,000 basis, the first $80,000 you withdraw is fully taxable as ordinary income. Only after you have pulled out all the gain do subsequent withdrawals become a tax-free return of principal.
Even a $10,000 withdrawal is fully taxable until the gain is exhausted. The insurance company reports the taxable portion on IRS Form 1099-R, which breaks out the gross distribution, the taxable amount, and the basis recovered.6Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Confirm those figures against what the insurer gave you in writing; correcting an inaccurate 1099-R later means going back to the carrier.
Annuitized Payments: The Exclusion Ratio
When you annuitize into periodic payments, each payment is split between taxable gain and tax-free return of basis using an exclusion ratio. The investment in the contract is divided by the total expected return over the payout period, and that percentage of every payment is tax-free.4Internal Revenue Service. Publication 939, General Rule for Pensions and Annuities The tax-free portion spreads across the whole payment stream rather than loading up at the end.
Ordinary Income Rates, Not Capital Gains
No matter how long the original owner held the annuity, the gain is taxed at ordinary income rates. Long-term capital gains treatment does not apply.5Internal Revenue Service. Publication 575, Pension and Annuity Income Twenty years of appreciation is taxed the same as a year-end bonus.
The 3.8% Net Investment Income Tax
The taxable gain counts as net investment income for the 3.8% Net Investment Income Tax. The NIIT applies when modified adjusted gross income exceeds $250,000 for married couples filing jointly, $200,000 for single filers, or $125,000 for married filing separately, and is calculated on the lesser of net investment income or the amount by which income exceeds the threshold.7Internal Revenue Service. Net Investment Income Tax A large single-year distribution can easily push you over, which is one more reason to spread withdrawals across years when the rules let you. The NIIT is reported on IRS Form 8960.
The IRD Deduction if Estate Tax Was Paid
If the deceased owner’s estate was large enough to owe federal estate tax, you get a partial income tax offset. The gain in a non-qualified annuity is income in respect of a decedent (IRD) under IRC Section 691. The IRS confirmed this in Revenue Ruling 2005-30, holding that amounts received by a beneficiary in excess of the owner’s investment in the contract are IRD.8Internal Revenue Service. Revenue Ruling 2005-30 – Income in Respect of a Decedent for Annuity Contracts
Section 691(c) lets you deduct the share of federal estate tax attributable to the annuity’s IRD value. The calculation compares the estate tax actually paid to the tax that would have been owed without the IRD items in the gross estate, and you claim your proportional share of the difference as an income tax deduction in the year you report the annuity income.9eCFR. 26 CFR 1.691(c)-1 – Deduction for Estate Tax Attributable to Income in Respect of a Decedent For estates below the federal estate tax exclusion that owed nothing, there is no IRD deduction to claim.
What Happens if You Miss a Deadline
Missing a required distribution triggers an excise tax under IRC Section 4974. The penalty is 25% of the shortfall between what should have been distributed and what was actually taken. If you correct the missed distribution within a designated correction window, the penalty drops to 10%.10eCFR. 26 CFR Part 54 – Pension Excise Taxes You report the penalty on IRS Form 5329 with your individual return.
For a beneficiary using the stretch who misses a year, the penalty applies to that year’s shortfall. For one under the five-year rule who fails to empty the account by the deadline, it applies to whatever balance remains. The IRS can waive the penalty if you show reasonable cause and take the missed distribution promptly, but a waiver is not guaranteed and requires a formal application.11Internal Revenue Service.