Inheriting an Annuity: What Are Your Options?

Losing a loved one is never easy. Along with the emotions of grief, families are often left to sort through financial accounts and decisions that feel overwhelming. Annuities are a common example: they can provide valuable benefits, but the rules for what happens when one is inherited aren’t always straightforward.

The most important thing to know is this: the rules depend on the type of annuity. In most cases, beneficiaries inherit either a non-qualified annuity (funded with after-tax dollars) or an IRA/qualified annuity (funded with retirement savings). Each scenario comes with different options, deadlines, and tax implications.

Here’s a breakdown to help you understand the possibilities.

Scenario 1: Inheriting a Non-Qualified Annuity (Most Common)

Taxation Basics

One of the biggest misconceptions about non-qualified annuities is that the entire lump sum is taxable. That’s not true. Only the growth (the gains above what your loved one originally invested) is taxable as ordinary income. The principal they contributed comes back to you tax-free.

Distribution Options

If you inherit a non-qualified annuity, you’ll usually have three choices:

• Lump-Sum Distribution
  • Provides immediate access to the money.
  • All taxable gains are recognized at once as ordinary income, which could push you into a higher tax bracket.
• 5-Year Rule
  • Withdrawals can be spread over up to five years, but the account must be fully distributed by the end of year five.
• Stretch Payments
  • Distributions are spread out over your life expectancy, which may lower your annual tax burden.
  • This option can be attractive if you don’t need the funds right away, or if much of the annuity value is from investment gains. 

Note: Not all annuities allow for stretch distributions. In some cases, a 1035 exchange into another annuity product may be necessary to access that option. This can help preserve tax deferral while giving you more flexibility.

• 1035 Exchange: A tax-free transfer of funds from one annuity contract to another. 

Deadlines & Decisions

Beneficiaries generally have one year from the date of death to elect a distribution method. Missing the deadline could limit your options.

Scenario 2: Inheriting an IRA Annuity

When the annuity is held inside an IRA or other qualified retirement account, the rules change.

Taxation Basics

Unlike non-qualified annuities, the entire distribution is taxable as ordinary income. There is no “principal” portion available to withdraw tax-free.

Distribution Options (Under the SECURE Act)

• 10-Year Rule
  • Most non-spouse beneficiaries must fully distribute the account within 10 years of the owner’s death.
  • How and when you take withdrawals during those 10 years can impact your tax bill.
• Eligible Designated Beneficiaries
  • Certain beneficiaries — surviving spouses, minor children, disabled or chronically ill individuals — may stretch distributions over their life expectancy.

Spousal Options

If you’re inheriting from a spouse, you typically have the ability to assume the IRA as your own. That means you can delay withdrawals until you reach your own required minimum distribution (RMD) age, offering greater flexibility and potential tax benefits.

Rolling Into an Inherited IRA

In many cases, an inherited IRA annuity can be rolled into an inherited IRA account instead. This may provide lower fees, broader investment choices, and more control over how the funds are managed. For some beneficiaries, this can be a more efficient and flexible option.

The Emotional Side

Sorting through these options can feel daunting — especially when you’re grieving. The key is not to rush. Take time to understand your choices, and don’t be afraid to lean on a financial professional to guide you. A thoughtful approach can help reduce unnecessary taxes and preserve more of the value your loved one intended for you to inherit.

Conclusion

Inheriting an annuity isn’t one-size-fits-all. The first step is to identify whether it’s non-qualified or held within an IRA. From there, the right path depends on your financial needs, tax situation, and long-term goals.

The most costly mistake beneficiaries make is acting too quickly or without advice. If you find yourself in this situation, pause, learn your options, and consult a professional who can help you make the decision that best honors your loved one’s legacy — and safeguards your own financial future.