What Is a Non-Qualified Stretch Annuity? Election, Payouts, and Tax

A non-qualified stretch annuity is an inherited annuity whose beneficiary has elected, under Internal Revenue Code Section 72(s), to take distributions over their own life expectancy instead of accepting a lump sum or liquidating the contract within five years. Because non-qualified annuities are bought with after-tax dollars, only the accumulated earnings are taxable when paid out, and spreading those earnings across decades keeps annual taxable income low and preserves tax-deferred growth on the balance that stays in the contract.¹

The Default Rule and the Life Expectancy Exception

When the owner of a non-qualified annuity dies before the annuity starting date, IRC 72(s) requires the entire account to be distributed within five years. If payments had already begun, the remaining interest must continue at least as fast as the existing schedule.¹

The stretch is the statutory escape from that five-year default. Three conditions have to be met: a designated beneficiary must be named, distributions must be structured over that beneficiary’s life or life expectancy, and payments must begin within one year of the owner’s death. When all three are satisfied, the law treats the account as distributed on the date payments began, and the contract keeps its annuity tax treatment. Without the election, the beneficiary faces a lump sum or a five-year drawdown, either of which concentrates the taxable earnings into a short window and often pushes the beneficiary into a higher bracket.

Who Can Elect the Stretch

Under IRC 72(s)(4), a “designated beneficiary” is any individual named by the contract holder. The operative word is individual. Corporations, charities, and estates cannot use the life expectancy method and are locked into the five-year rule.¹

Surviving Spouses

A surviving spouse who is the designated beneficiary can be treated as the new owner of the contract under IRC 72(s)(3). This spousal continuation option means the contract keeps growing tax-deferred, no distributions are required, and the spouse can name their own beneficiary. Neither the five-year rule nor the one-year distribution deadline applies.

Non-Spouse Beneficiaries

Children, grandchildren, and other non-spouse individuals are the primary users of the stretch. They must begin receiving distributions within one year of the owner’s death and take payments over their own life expectancy. A younger beneficiary gets a longer payout period, smaller required distributions, and more time for the remaining balance to compound.

Trusts

A trust named as beneficiary generally cannot stretch because a trust is not an individual. The exception is a see-through (or look-through) trust, which the IRS may treat as though the trust’s individual beneficiaries are the designated beneficiaries. To qualify, the trust must be valid under state law, be irrevocable or become irrevocable at the owner’s death, have identifiable individual beneficiaries, and provide the required documentation to the carrier. When it qualifies, the oldest individual beneficiary’s life expectancy governs the schedule. Trust language has to be drafted with this purpose in mind; a drafting error collapses the entire stretch.

The One-Year Deadline and Annual Payment Calculation

The one-year window is rigid. A non-spouse beneficiary must begin distributions no later than one year after the owner’s death.¹ Miss it, and the contract defaults to the five-year rule. There is no waiver process and no penalty form; the opportunity simply lapses.

Once the stretch is elected, the carrier divides the contract value by the beneficiary’s life expectancy factor from IRS tables, using the beneficiary’s age at the first distribution. Each subsequent year the factor is reduced by one, which gradually raises the percentage that must be withdrawn. A 35-year-old beneficiary might start with a factor near 50, meaning roughly 2% of the account comes out in year one. A 65-year-old faces a much shorter factor and correspondingly larger required withdrawals.

These distributions are mandatory. The beneficiary cannot skip a year or defer a payment, and the required amount must be withdrawn by December 31 of each calendar year.² Taking more than the minimum in any year is permitted, but it does not reduce future required amounts.

How the Distributions Are Taxed

Periodic Stretch Payments

Regular stretch distributions are taxed under what the IRS calls the General Rule. Each payment is split into a taxable portion (accumulated earnings) and a tax-free portion (return of the after-tax investment). The split is set by an exclusion ratio: the original investment divided by the total expected return over the beneficiary’s life expectancy.³ If the owner invested $100,000 and the expected return is $200,000, half of each payment is tax-free. After the full cost basis is recovered, every dollar of every subsequent payment is fully taxable as ordinary income.

Lump-Sum or Non-Periodic Withdrawals

Take a lump sum or a withdrawal outside the schedule before the annuity starting date, and the tax rule flips to earnings-first (last in, first out). The entire withdrawal is taxable earnings until all gains have come out, and only then does tax-free basis recovery begin.⁴ That is a far worse tax outcome than the blended treatment of periodic stretch payments, and it is one of the strongest reasons to make the election.

No Step-Up in Basis

Non-qualified annuities do not receive a step-up in cost basis at the owner’s death. The beneficiary inherits the owner’s basis, which is the after-tax amount invested minus any lifetime withdrawals. Every dollar of gain above that carried-over basis eventually becomes ordinary income. That is a real disadvantage compared to inherited stocks or real estate, where the step-up can wipe out capital gains entirely.

The SECURE Act Did Not Change This

This is the point where planning goes wrong. The SECURE Act of 2019 eliminated the stretch for most inherited IRAs and qualified retirement accounts and replaced it with a 10-year liquidation rule for non-spouse beneficiaries. That change amended IRC 401(a)(9) and left IRC 72(s) alone. Non-spouse beneficiaries of non-qualified annuities can still elect life expectancy payouts with no 10-year deadline.

Someone who owns both an IRA and a non-qualified annuity, and who wants to leave stretched income to their children, will find that the annuity offers a longer horizon than the IRA. That is why some planners suggest spending down IRA assets in retirement and preserving non-qualified annuity value: the stretch still works there.

What Happens If the Rules Are Missed

The consequence of failing the 72(s) distribution requirements is not a percentage penalty on the shortfall. It is that the contract loses its status as an annuity for federal tax purposes. The statute is explicit: “a contract shall not be treated as an annuity contract” unless it provides for the required distributions.¹ Fail the test and the entire accumulated gain could become immediately taxable. The 25% excise tax on missed distributions that applies to qualified plans under IRC 4974 does not reach non-qualified annuities, so the outcome here is binary: the contract either satisfies 72(s) and keeps its tax deferral, or it does not and the shelter is gone.⁵

Making the Election With the Carrier

The stretch election is filed with the insurance carrier, not the IRS. Start by contacting the carrier or the deceased owner’s financial advisor and requesting a death benefit claim. Standard documentation includes a certified death certificate, the beneficiary’s Social Security number and date of birth, and the original contract number.

The carrier provides a claim form, sometimes labeled a Stretch Election or Beneficiary Distribution Election form. On it, the beneficiary must explicitly choose the life expectancy option. Most carriers default to a lump sum when no election is made, so leaving that blank or delaying the paperwork past the one-year mark can forfeit the stretch. The form also handles federal tax withholding.

Once the account is set up, distributions begin on the life expectancy schedule and the carrier issues a Form 1099-R each year showing the gross distribution and the taxable portion.⁶ Check each 1099-R against the exclusion ratio; errors that treat tax-free basis recovery as taxable income are more common than they should be, and they are much easier to fix in the year they occur. Some carriers also waive remaining surrender charges when processing a death benefit claim, but that varies by contract, so ask before assuming.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
3
Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
4
Internal Revenue Service. Publication 575 – Pension and Annuity Income
5
GovInfo. 26 CFR 54.4974-1 – Excise Tax on Accumulations in Qualified Retirement Plans
6
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.