How is an inherited annuity taxed? In most cases the growth inside the contract is taxed to the beneficiary as ordinary income when it is paid out, because an annuity does not receive the “step-up” in cost basis that many inherited investments get (Source: IRC section 72; IRS Publication 575, 2025). The rest of this guide explains which dollars are taxable, how payout choices change the timing, and where the rules for spouses differ from other beneficiaries.
An inherited annuity is generally taxed to the beneficiary as ordinary income on the earnings (gain above the owner’s cost), not at capital-gains rates, and there is typically no step-up in basis (Source: IRC section 72; IRS Publication 575, 2025). Distributions made on or after the death of the holder are excepted from the 10% additional tax that otherwise applies before age 59½ (Source: IRC section 72(q)(2)(B)). Timing and amount depend on the payout option chosen.
What “inherited annuity” means here (and what this guide does not cover)
An inherited annuity is an annuity contract received as a named beneficiary after the original owner or annuitant dies. This guide covers the federal taxation of that contract at death, not the decision to buy an annuity while alive. Two broad categories follow different rulebooks: nonqualified annuities and qualified annuities held inside retirement accounts. Each is addressed below.
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A nonqualified annuity is bought with after-tax dollars and follows Internal Revenue Code section 72 (Source: IRC section 72; IRS Publication 575, 2025). A qualified annuity held inside an IRA or an employer plan follows the inherited-retirement-account rules instead. If the inheritance is an IRA rather than a standalone annuity, the inherited-IRA distribution rules govern; annuities held inside those accounts generally follow the same account-level timing (Source: IRS Publication 590-B, 2025).
How is an inherited annuity taxed at the federal level?
An inherited annuity is generally taxed as ordinary income on its gain, meaning the earnings above the deceased owner’s investment in the contract are added to the beneficiary’s taxable income in the year received. Annuity gain does not qualify for long-term capital-gains rates, and the contract typically does not receive a step-up in basis at death (Source: IRC section 72; IRS Publication 575, 2025).
The taxable portion is the difference between what is distributed and the owner’s cost basis (the after-tax premiums originally paid). Only that cost basis is recovered tax-free; everything above it is treated as ordinary income under the section 72 framework (Source: IRS Publication 575, 2025). Because ordinary income is taxed at the beneficiary’s marginal rate, the size of a distribution in a given year is a factor in the total tax owed.
Ordinary-income inclusions can also interact with other thresholds. Larger distributions may affect exposure to the Net Investment Income Tax, Medicare premium tiers under IRMAA, and the taxable share of Social Security described in the Social Security tax torpedo, depending on your other income.
No step-up in basis, and gains come out first
An inherited annuity is generally not treated like inherited stock or a home. There is generally no step-up in basis, and for withdrawals not paid as a scheduled annuity, the taxable earnings are treated as coming out first, a last-in, first-out approach (Source: IRC section 72(e); IRS Publication 575, 2025). That combination means early, partial withdrawals from an inherited nonqualified annuity are often fully taxable until the gain is exhausted.
By contrast, an inherited brokerage account can receive a step-up that resets basis to date-of-death value and eliminates prior gain (Source: IRC section 1014). An annuity does not offer that reset, so the deferred earnings remain taxable when distributed. These mechanics are factors a beneficiary may weigh when reviewing how and when to take the money.
Spouse versus non-spouse beneficiaries
A surviving spouse and a non-spouse beneficiary generally have different options. Under IRC section 72(s), a surviving spouse who is the designated beneficiary may be treated as the holder and continue the contract, keeping tax deferral in place. A non-spouse beneficiary generally must begin distributions under a statutory schedule (Source: IRC section 72(s)). The table below outlines common paths; exact choices depend on the contract and current law.
| Beneficiary type | Common options | Tax timing (general) |
|---|---|---|
| Surviving spouse | Continue the contract as owner; or take distributions | Continuation defers tax; gains taxed as ordinary income when withdrawn |
| Non-spouse (nonqualified annuity) | Full distribution within 5 years of death; or, if payments begin within 1 year, a stream over the beneficiary’s life or life expectancy | Ordinary income as received; spreading distributes the taxable gain across more years |
| Non-spouse (annuity inside an IRA) | Follows inherited-IRA account rules (commonly the 10-year rule) | Ordinary income; account-level distribution deadlines apply |
Under IRC section 72(s), if the holder dies before the annuity starting date, the entire interest generally must be distributed within 5 years, unless the payable portion goes to a designated beneficiary as a life or life-expectancy stream beginning within 1 year of death (Source: IRC section 72(s)). Spousal continuation postpones recognition of the gain, while a non-spouse beneficiary generally cannot continue the contract indefinitely. Whether one option defers more tax than another depends on the beneficiary’s circumstances.
How payout options change the tax timing
The payout method a beneficiary selects affects when the ordinary income is recognized, not whether it is taxed. A lump sum recognizes all remaining gain at once, while distributions over several years or over a life-based payout move the income into more tax years. The underlying rule is constant: the earnings portion is ordinary income, and only the timing changes (Source: IRC section 72; IRS Publication 575, 2025).
- Lump sum. All gain becomes taxable in one year, which can affect the beneficiary’s marginal bracket and other income-based thresholds.
- 5-year window. Distributions are spread across up to 5 years under IRC section 72(s), splitting the taxable gain into smaller annual pieces.
- Life-based payout stream. Payments spread over the beneficiary’s life expectancy. For a nonqualified annuity, each payment’s tax-free portion is figured under the General Rule using an exclusion ratio; qualified plan payouts generally use the Simplified Method (Source: IRS Publication 575 and Publication 939, 2025).
Because the earnings come out ahead of basis on non-annuitized withdrawals, small early withdrawals are often fully taxable (Source: IRC section 72(e)). Some beneficiaries review these mechanics alongside other retirement items such as a Roth conversion or account withdrawals subject to required minimum distribution rules.
Does the 10% early-distribution penalty apply to beneficiaries?
Beneficiaries generally do not owe the 10% additional tax on early distributions simply because they are under age 59½. For nonqualified annuities, distributions made on or after the death of the holder are an enumerated exception to that additional tax (Source: IRC section 72(q)(2)(B)). Death is also a listed exception for distributions from qualified retirement plans and IRAs (Source: IRC section 72(t)(2)(A)(ii)).
Separately, the generic reporting mechanics are as follows: the 10% additional tax equals 10% of the portion of a distribution that is includible in gross income, applies before age 59½, is reported on Schedule 2 (Form 1040), and Form 5329 is filed when the Form 1099-R distribution code does not document an exception (Source: IRS Tax Topic 558, 2026). Because qualified and nonqualified annuities cite different Internal Revenue Code sections, the applicable exception depends on the contract type.
How cost basis and income in respect of a decedent apply
An inherited annuity’s taxable amount depends on the owner’s cost basis, the after-tax premiums originally paid. Under IRC section 72, that basis returns tax-free, and only the gain above it is ordinary income. The deferred gain is income in respect of a decedent, so it does not receive a step-up and stays taxable to the beneficiary (Source: IRC sections 72 and 1014(c)).
Income in respect of a decedent (IRD) is income the deceased owner earned or accrued but had not yet recognized for tax purposes. Because the tax on that income was deferred during the owner’s life, section 1014(c) excludes IRD assets from the general step-up rule that applies to most inherited property (Source: IRC section 1014(c)). Traditional IRAs, 401(k) balances, and deferred annuity gain are common examples of IRD.
Where a beneficiary receives IRD and the estate paid federal estate tax on that item, an income-tax deduction for estate tax attributable to the IRD may be available under IRC section 691(c) (Source: IRC section 691(c); IRS Publication 559). Whether this deduction applies depends on whether estate tax was actually paid, which is a fact specific to each estate.
For a nonqualified annuity, the cost basis figure comes from the contract records and the insurer’s Form 1099-R reporting. For a qualified annuity funded with pre-tax dollars, there is generally no basis to recover, so distributions are fully taxable as ordinary income when received (Source: IRS Publication 575, 2025). Confirming which category applies is the starting point for any basis calculation.
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Frequently asked questions
Do you pay taxes on an inherited annuity?
Yes, in most cases. The earnings portion of an inherited annuity (the gain above the deceased owner’s cost basis) is generally taxable to the beneficiary as ordinary income when distributed. The return of the owner’s original after-tax investment is typically not taxed again. The exact taxable amount depends on the contract’s basis and the payout option chosen.
Is an inherited annuity taxed as ordinary income or capital gains?
Inherited annuity gains are generally taxed as ordinary income, not at the lower long-term capital-gains rates (Source: IRC section 72). Annuities do not receive capital-gains treatment on their internal earnings, and they typically do not get a step-up in basis at death because annuity gain is income in respect of a decedent (Source: IRC section 1014(c)). The resulting tax depends on the beneficiary’s ordinary-income bracket.
How is the tax on an inherited annuity determined?
The taxable amount is the gain, the distribution above the owner’s after-tax cost basis, and it is ordinary income when received (Source: IRC section 72). The rules do not remove that tax, but the timing follows the payout method chosen. A lump sum recognizes all gain in one year; a multi-year or life-based stream spreads it across more years. Outcomes vary by circumstance.
What happens when a spouse inherits an annuity?
Under IRC section 72(s), a surviving spouse who is the designated beneficiary may be treated as the holder and continue the annuity, keeping tax deferral in place until distributions are taken. When the spouse later withdraws money, the earnings are generally taxed as ordinary income. This continuation option is generally unavailable to non-spouse beneficiaries, who typically must begin distributions under a statutory schedule.
Is there a penalty for cashing out an inherited annuity early?
Beneficiaries generally avoid the 10% additional tax that applies before age 59½, because distributions made on or after the owner’s death are an enumerated exception (Source: IRC section 72(q)(2)(B) for nonqualified annuities; IRC section 72(t)(2)(A)(ii) for qualified plans and IRAs). Where it does apply, that tax equals 10% of the includible portion and is reported on Schedule 2 (Form 1040) (Source: IRS Tax Topic 558, 2026).
Sources
Internal Revenue Code section 72, “Annuities; certain proceeds of endowment and life insurance contracts,” including 72(e) (nonperiodic distribution ordering), 72(q)(2)(B) (death exception to the additional tax on nonqualified annuities), 72(s) (required distributions where the holder dies), and 72(t)(2)(A)(ii) (death exception for qualified plans and IRAs), https://www.law.cornell.edu/uscode/text/26/72. Internal Revenue Code section 1014 and 1014(c) (basis of property acquired from a decedent; income in respect of a decedent), https://www.law.cornell.edu/uscode/text/26/1014. Internal Revenue Code section 691 and 691(c) (recipients of income in respect of decedents; deduction for estate tax attributable to IRD), https://www.law.cornell.edu/uscode/text/26/691. IRS Publication 559, “Survivors, Executors, and Administrators,” https://www.irs.gov/publications/p559. IRS Publication 575, “Pension and Annuity Income” (2025), https://www.irs.gov/publications/p575. IRS Publication 939, “General Rule for Pensions and Annuities” (2025), https://www.irs.gov/publications/p939. IRS Publication 590-B, “Distributions from Individual Retirement Arrangements (IRAs)” (2025), including the 10-year rule for most non-spouse beneficiaries, https://www.irs.gov/publications/p590b. IRS Tax Topic 558, “Additional Tax on Early Distributions From Retirement Plans Other Than IRAs” (2026), https://www.irs.gov/taxtopics/tc558. Readers should confirm current-year figures directly with these primary sources or a tax professional.
