Inherited an Annuity? Here's How Taxes Really Work
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Inheriting an annuity can feel like a financial win until taxes enter the picture. The big question most people ask right away is simple: how much of this money will I get to keep? The answer depends less on who you are and more on how the annuity was set up, how you take the money, and whether you are a spouse or another beneficiary.
At its core, an inherited annuity is taxed as income when you withdraw money from it, as there is no inheritance annuity tax rate. Instead, withdrawals are added to your regular income and taxed at your usual tax bracket. That is why decisions about timing and payout method matter so much.
What Exactly Are You Inheriting?
An annuity is a contract with an insurance company. The original owner pays into it, and the insurer agrees to pay money back either right away or later. Immediate annuities start paying almost at once, while deferred annuities can sit untouched for years before payouts begin.
When the owner dies, the annuity does not vanish. If beneficiaries were named, the remaining value or a guaranteed amount passes to them. Spouses, children or even non-family members can inherit an annuity.
Here’s Why Taxes Depend on How the Annuity Was Funded
The most important tax distinction is whether the annuity is qualified or non-qualified. A qualified annuity was funded with pre-tax dollars, often through a retirement plan, such as a traditional 401(k) or traditional IRA. A non-qualified annuity was bought with after-tax money.
If you inherit a qualified annuity, every dollar you withdraw is taxable as ordinary income. With a non-qualified annuity, only earnings are taxed. The original principal comes back tax-free because it was already taxed when it was contributed.
This single difference can change your tax bill dramatically, especially if the annuity has been growing for many years.
How Payout Choices Shape Your Tax Bill
After inheriting an annuity, beneficiaries are usually allowed to choose how they receive the money. You may take everything at once, spread payments over several years, or stretch them out based on life expectancy. Each option carries a different tax impact.
A lump sum is often the most tempting and the most expensive choice. Pulling all the money out in one year can push you into a higher tax bracket and lead to a much larger tax bill. Spreading payments over time usually keeps income lower each year, which can mean paying less overall tax.
Special Rules for Surviving Spouses
Spouses get the most flexibility with inherited annuities. In many cases, a surviving spouse can continue the annuity under the original terms, taking payments over their life expectancy. This approach does not eliminate taxes, but it often reduces them by spreading income over many years.
Other options, like lump sums or five-year payouts, are still available. These may make sense for short-term cash needs, but they usually increase the tax hit. The key trade-off is access now versus taxes later.
What Non-Spouse beneficiaries need to know
If you inherit an annuity and you are not the spouse, you cannot take over the ownership of the contract. You still get payout choices, but they are more limited. You can take a lump sum, spread payments over five years, or stretch them based on life expectancy, depending on the contract.
For qualified annuities tied to retirement accounts, the SECURE Act adds another layer. Most non-spouse beneficiaries must withdraw all the money within 10 years of the owner’s death. Missing this deadline can trigger a steep penalty on what is left in the account.
Can Rolling Over an Inherited Annuity Help?
In some situations, rolling an inherited annuity into another qualified annuity or an inherited IRA can delay taxes. This only works if strict rules are followed, and not everyone is eligible. When it is allowed, the rollover avoids immediate taxation and shifts the money under a new set of distribution rules.
Because mistakes can be costly, this is one area where professional advice is often worth it.
Bottom Line
Inherited annuities are not taxed upfront, but they are taxed when you take money out. How much you pay depends on the annuity type, your payout choice and your income tax bracket. Taking time to understand these rules before touching the money can help you keep more of what was passed on to you.