Inherited Annuity: Payout Options and How Gains Are Taxed

An annuity pays its death benefit straight to the named beneficiary, outside probate. A surviving spouse can often continue the contract as the new owner; everyone else picks from the contract’s payout options on a deadline. The tax rule to hold onto: the gains are ordinary income, and annuities never get the step-up in basis other inherited assets do.

By Settled Estate Editorial Team · Published: August 22, 2026

The short answer

The insurer pays whoever the beneficiary form names, once it has the death certificate and claim form. The will has no say, and the money does not wait for probate. The decisions live on the claim paperwork: which payout option, on what schedule, and (for a spouse) whether to keep the contract alive instead of taking anything at all.

Spouses: continuation

A surviving spouse who is the sole beneficiary can usually elect spousal continuation: they become the owner, the contract keeps its tax deferral, and no payout is forced. Continuation is not automatically the right call. The contract keeps its fees and surrender schedule too, and a contract that made sense for the buyer at 60 may fit the survivor at 80 badly. The election is one-way, so it is worth a conversation with a tax professional or fee-only advisor first.

Everyone else: the payout choices

Lump sum. Simple, and it recognizes all the deferred gain as income in one year.
Spread payments. Nonqualified contracts commonly allow distributions across five years, and some beneficiaries and contracts permit a longer life-expectancy stretch. Spreading keeps the gains from stacking into one bracket.
Annuitization. Convert the death benefit into a payment stream under the contract’s terms.

The options and their election deadlines are contract-specific, and the insurer’s claim kit is the controlling paperwork. Deadlines matter: missing an election window can default the contract into its least flexible option.

How the taxes work

A nonqualified annuity splits into two layers: the owner’s after-tax contributions, which return to the beneficiary tax-free, and the deferred earnings, which are ordinary income as received. There is no step-up in basis; annuity gains are income in respect of a decedent, the same category that keeps retirement accounts outside the step-up rule. Payout timing is the one lever the beneficiary controls, because it decides which years absorb the income.

Annuities inside retirement accounts

An annuity held inside an IRA or 401(k) is retirement money first: the account rules (including the 10-year rule for most non-spouse beneficiaries) control the schedule, and withdrawals are generally taxable in full. The contract layer still decides what payout shapes are available inside that window. Our inherited IRA guide carries those rules.

If you are also settling the estate itself, a short assessment shows which probate process applies.

Frequently Asked Questions

What happens to an annuity when the owner dies?

The contract pays its death benefit to the named beneficiary directly, outside probate. What the beneficiary can do next depends on the contract and who they are: a surviving spouse can often step in as the new owner and continue the contract, while other beneficiaries choose among the contract’s payout options within the deadlines the tax rules set.

Is an inherited annuity taxable?

The earnings are. A nonqualified annuity’s gains (the value above what the owner paid in) are ordinary income to the beneficiary as received, and inherited assets like annuities get no step-up in basis. The original after-tax contributions come back tax-free. An annuity held inside an IRA or 401(k) follows retirement-account rules instead, which usually tax every dollar withdrawn.

What payout options does a beneficiary have?

Typical contracts offer a lump sum, payments spread over a period the tax rules allow (nonqualified contracts commonly allow five years, and some beneficiaries can stretch over life expectancy where the contract and rules permit), or annuitized payments. Options and election deadlines vary by contract, so the insurer’s claim paperwork is the controlling document.

Can a spouse keep the annuity going?

Often, yes. Most contracts and the tax rules let a surviving spouse who is the sole beneficiary elect spousal continuation: they become the owner, the contract keeps growing tax-deferred, and no death payout is forced. Whether continuing is wise depends on the contract’s terms and fees, which is a question for a fee-only advisor or tax professional rather than the selling agent.

Information current as of August 22, 2026

Settled Estate is not a law firm, and this content is for informational purposes only and does not constitute legal advice. Probate laws and procedures in your state can change. Consult with a qualified attorney for advice specific to your situation. Full disclaimer.