Yes, an inherited annuity is almost always taxable. How much you owe depends on whether the contract was funded with pre-tax or after-tax dollars and how you choose to take the money out. The federal government treats annuity growth as deferred income rather than a simple inheritance, so the income tax the original owner postponed passes to you as the beneficiary. Ordinary income rates apply, and the top federal rate reaches 37% for 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Most states add their own income tax on top of that.
Qualified or Non-Qualified Determines How Much Is Taxable
The single biggest factor in your tax bill is whether the annuity you inherited was qualified or non-qualified.
A qualified annuity sits inside a tax-advantaged retirement account like a 401(k) or traditional IRA. The original owner contributed pre-tax money and never paid income tax on any of it. Every dollar you withdraw is fully taxable as ordinary income. If the owner contributed $100,000 in pre-tax dollars and the account grew to $250,000, you owe income tax on the full $250,000 as you take distributions. A beneficiary reports annuity income the same way the plan participant would have.2Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income – Section: Survivors and Beneficiaries
A non-qualified annuity was purchased with after-tax money outside a retirement plan. Because the owner already paid tax on the premiums, you owe income tax only on the growth. The original investment (the cost basis) comes back to you tax-free. That difference can save thousands, but it doesn’t get you capital gains rates. The earnings are still taxed at your ordinary income rate.
How the Taxable Portion Is Split on a Non-Qualified Annuity
How the IRS separates taxable earnings from tax-free basis depends on your distribution method.
If you annuitize the contract and receive regular periodic payments, an exclusion ratio under IRC Section 72(b) splits each payment into a taxable portion (earnings) and a tax-free portion (return of basis).3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts If your basis makes up 45% of the expected return, 45% of each payment is tax-free.
If you take withdrawals instead of annuitizing, a less favorable rule applies. Under IRC Section 72(e), any amount withdrawn before the annuity starting date is treated as taxable earnings first, until all the growth has been pulled out.3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Only after you exhaust the earnings do withdrawals start coming from your tax-free basis. This “income-first” order front-loads the tax bill into the early years.
Inherited Annuities Do Not Get a Step-Up in Basis
When you inherit stocks or real estate, the cost basis generally resets to the fair market value at the date of death, wiping out built-in gains. Annuities are specifically excluded from that benefit because they contain income in respect of a decedent. Accumulated earnings inside the contract remain taxable to you, just as they would have been to the original owner.
Distribution Method Sets the Timing and Size of the Tax Bill
The way you take the money out controls how quickly the tax arrives and how much lands in any single year. IRC Section 72(s) sets the baseline for non-qualified contracts, and the SECURE Act governs qualified accounts.3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
- Lump sum. You take the entire account value at once. All taxable earnings hit your return in a single year, which can push you into a higher bracket and shrink your net inheritance.
- Five-year rule. You can withdraw on any schedule you choose, as long as the account is empty by December 31 of the fifth year after the owner’s death.
- Ten-year rule. For most non-spouse beneficiaries of qualified accounts, this is the default under the SECURE Act. The account must be fully distributed by the end of the tenth year following the owner’s death, and you can take money out in any pattern during that decade.4Internal Revenue Service. Retirement Topics – Beneficiary
- Life expectancy (stretch) method. Available only to eligible designated beneficiaries, this spreads payments over your remaining life expectancy, keeping annual taxable income small and letting the rest keep growing tax-deferred.
Eligible designated beneficiaries include the surviving spouse, minor children of the account holder, disabled or chronically ill individuals, and beneficiaries who are not more than ten years younger than the deceased owner. Everyone else is stuck with the ten-year window on qualified accounts.4Internal Revenue Service. Retirement Topics – Beneficiary
Choosing among these methods means looking at your current income, your expected income over the coming years, and how many years you have before the hard deadline. Someone in a temporarily low-income year may benefit from a larger withdrawal that year. Someone already in the top bracket gains nothing from spreading distributions out.
Spouses Have Options No Other Beneficiary Gets
If you’re the sole beneficiary of a qualified inherited annuity and you’re the surviving spouse, you can roll the account into your own IRA and treat it as if it were always yours.4Internal Revenue Service. Retirement Topics – Beneficiary The distribution clock resets. You won’t face required minimum distributions until the applicable RMD age (currently 73, rising to 75 in 2033), and the account keeps growing tax-deferred.
There’s a trade-off. Once the money is in your own IRA, a withdrawal before age 59½ triggers the standard 10% early withdrawal penalty that wouldn’t apply to an inherited account. Younger surviving spouses who might need the money before 59½ often do better keeping the annuity in inherited status.
For a non-qualified inherited annuity, a surviving spouse can often continue the contract by stepping into the original owner’s role. The annuity keeps growing tax-deferred without triggering any immediate tax event.
No 10% Early Withdrawal Penalty on Inherited Annuities
Under IRC Section 72(t)(2)(A)(ii), distributions made to a beneficiary after the death of the account holder are exempt from the 10% additional tax on early distributions, regardless of your age.5Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions If you’re 35 and inherit a qualified annuity, you’ll owe ordinary income tax on what you withdraw but won’t face the extra 10% penalty that normally applies before 59½.
The exception, again: a surviving spouse who rolls the inherited annuity into their own IRA loses this protection, because the account is now their own.
Missing a Deadline Triggers an Excise Tax
Missing a required distribution triggers a steep excise tax. SECURE 2.0 reduced the penalty from the old 50% rate to 25% of the amount you failed to withdraw on time.6Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs If you catch the mistake and take the distribution within two years, the penalty drops to 10%.7Internal Revenue Service. Distributions From Individual Retirement Arrangements (IRAs)
You report and pay the excise tax on IRS Form 5329. The tax applies to the shortfall. If your required distribution was $20,000 and you took only $12,000, the 25% hits the missing $8,000. This is where the ten-year rule becomes a trap for procrastinators: defer everything until year ten and fail to liquidate by December 31 of that year, and the penalty stacks on top of the income tax you already owe.
Roth Annuities Flip the Picture
Contributions to a Roth IRA or Roth 401(k) were made with after-tax dollars, and qualified distributions are entirely tax-free. When you inherit a Roth annuity, withdrawals of contributions come out tax-free. Earnings are also tax-free as long as the Roth account was open for at least five years before the withdrawal.4Internal Revenue Service. Retirement Topics – Beneficiary
If the account is less than five years old at the time of withdrawal, the earnings portion may be subject to income tax. The contribution portion still comes out tax-free. Non-spouse beneficiaries are still subject to the ten-year distribution rule for inherited Roth accounts, but the tax-free nature of the payouts makes the deadline far less painful.
State Income Tax Is Usually on Top
Most states also tax inherited annuity distributions as ordinary income, with rates ranging from 0% in states with no income tax to over 13% in the highest-tax states. A handful of states offer partial exemptions for retirement income, but the exemptions vary widely and may not cover annuity distributions specifically. In a high-tax state, the combined federal and state rate on a large lump sum can approach 50%.
Estate Tax Only Hits Large Estates
Income tax is one bill. Estate tax is a separate one, paid by the estate rather than by you. The fair market value of an inherited annuity is included in the deceased person’s gross estate, and if the total estate exceeds the federal exemption threshold, currently $15 million per individual for 2026, the estate may owe federal estate tax.8Internal Revenue Service. What’s New – Estate and Gift Tax The executor reports these values on IRS Form 706.9Internal Revenue Service. Estate Tax
For estates that do owe estate tax, beneficiaries can face what amounts to double taxation on the annuity. IRC Section 691(c) provides an income in respect of a decedent (IRD) deduction on your own federal income tax return for the share of estate taxes attributable to the annuity.10Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents Below the $15 million threshold, this doesn’t come up.
How to Report What You Receive
The insurance company or plan administrator will send you a Form 1099-R for any distributions you receive during the year. Inherited annuity payments are typically reported with distribution code 4 (death), which tells the IRS the payment went to a beneficiary rather than the original account holder.11Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498 You report the taxable portion on your federal return as ordinary income.
If you inherited a qualified annuity and expect to owe $1,000 or more in tax after credits and withholding, you may need to make estimated tax payments during the year to avoid an underpayment penalty.12Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income – Section: Withholding Tax and Estimated Tax Insurers withhold tax from periodic payments unless you file Form W-4P electing otherwise, and withholding on lump-sum or non-periodic distributions is often a flat default rate that may not cover your actual liability. Running the numbers early in the year beats a surprise bill in April.