Inheriting an Annuity
Most assets inherited from someone who died get a fresh cost basis, so the gain built up over their lifetime is never taxed. A non-qualified annuity is one of the exceptions. The whole gain inside the contract remains taxable, it is taxed as ordinary income rather than capital gain, and the beneficiary pays it.
- No step-up:: Unlike shares or property, the basis does not reset at death. The whole embedded gain remains taxable.
- Ordinary income:: The gain is taxed at income rates, not the lower long-term capital gains rates.
- The payout choice decides the tax:: A lump sum bunches the entire gain into one year. Spreading it over several spreads the tax.
- A spouse has an extra option:: A surviving spouse can generally continue the contract as their own, deferring everything.
Where the AI summary above gets this wrong
"Inherited assets get a step-up in basis, so there is no tax on the gain."
That's surface-true. Here's what it misses:
- Annuities are an exception to the step-up — The step-up rule people know from shares and property does not apply to a non-qualified annuity. Its gain is income in respect of a decedent, and the beneficiary inherits the tax with the asset. Assuming otherwise produces an unwelcome surprise the following April.
- The gain is ordinary income, not capital gain — Even where the underlying investments were equities, the gain comes out at ordinary income rates. That makes an inherited annuity one of the most heavily taxed things to inherit, and it argues for spreading the payout rather than taking it in one piece.
- The default payout is often the worst one — Insurers frequently default to a lump sum, and a grieving beneficiary signs the form in front of them. Electing instead to take payments over a period, where the contract allows it, can move the same money into several lower-rate years, and the election generally has to be made within a window after the death.
01 Why there is no step-up
When someone dies, most capital assets get a new cost basis equal to the value at death, which is the mechanism behind holding appreciated assets for life. A non-qualified annuity does not qualify for that treatment.
The gain inside the contract — the excess over what the original owner paid in — is income in respect of a decedent. It was never taxed during the owner's life because the annuity deferred it, and death does not forgive that deferral. The beneficiary receives the asset and the tax liability together.
The original owner's investment in the contract does come across, so the return of that portion is not taxable. Establishing what that figure is, from the insurer's records, is the first thing to do.
Source: Publication 575
02 The payout options
A lump sum pays the whole contract at once and taxes the entire gain in a single year. For a large contract that can push a beneficiary through several brackets and into surcharge territory on Medicare premiums if they are old enough for it to matter.
Spreading the payments over a period, or over a life expectancy where the contract offers it, moves the same gain across multiple years. Each payment is then part taxable gain and part tax-free return of the original investment, which is a materially better outcome at almost every income level.
Elections are time-limited. Insurers generally require the choice within a defined period after the death, and a beneficiary who does nothing may find the default applied. Ask what the deadline is before signing anything.
Shows: the income tax on the gain inside an inherited annuity if the whole contract is cashed in one year, at the rate you enter. Ignores: state tax, the effect of the income on Medicare premiums and Social Security taxation, and the far lower tax that spreading the payout over several years usually produces.
03 Spouses, and annuities inside retirement accounts
A surviving spouse named as beneficiary can generally continue the contract as their own, which defers the whole question until they take money out. That is almost always the strongest option, and it is not available to anyone else.
An annuity held inside an IRA or an employer plan is a different animal. There the account rules govern — the ten-year deadline and the distribution requirements described in the distribution rules — rather than the annuity rules described here. Establishing which kind you have inherited is the first question, not the second.
Where several beneficiaries share one contract, each is generally treated separately, so one taking a lump sum does not force the others to. That is worth knowing before a family agrees on a single approach for convenience.
Source: Publication 575
The mistake here happens in a week when nobody should be making financial decisions. A form arrives from the insurer, lump sum is the obvious box, and a hundred thousand dollars of deferred gain lands in one tax year. If you are the beneficiary of an annuity, the only urgent task is to find out what the election deadline is and what options the contract offers. Everything else can wait; that cannot, and it is worth more than any investment decision that follows.
FAQ
Do I get a step-up in basis on an inherited annuity?
No. A non-qualified annuity is an exception to the step-up rule. The gain above the original owner's investment in the contract stays taxable and passes to you with the asset.
How is an inherited annuity taxed?
The gain is taxed as ordinary income at your rates, not at capital gains rates. The return of the original owner's investment in the contract is not taxable.
Should I take a lump sum from an inherited annuity?
Usually not, if the contract allows an alternative. A lump sum taxes the whole gain in one year at your highest rates; spreading payments moves the same money into several lower-rate years.
Sources
Regulator references
- Publication 575 · Internal Revenue Service · 2026How annuity payments are taxed and how the investment in the contract is recovered.Last verified: 2026-09-07
- Topic 410: pensions and annuities · Internal Revenue Service · 2026The taxable portion of an annuity payment and how it is reported.Last verified: 2026-09-07
Calculator unit tests · the assertions this page's worked example is checked against, and their last result
Changelog
- 2026-09-07 — initial publish (new format)
Run this rule against your situation
See what this rule does to your own projection — month by month, to age 90.
Join the Waitlist
Jordan Reeves
Founder of Talk Through Wealth. A software engineer for over a decade before turning to retirement planning, Jordan built the projection engine after watching family members get fragmented, country-by-country advice that never reconciled. He writes about retirement the way the engine computes it: month-by-month, lifetime-long, and skeptical of any rule of thumb that hasn't been run through the math.