Inherited Annuities: Stretch Provisions and Tax Treatment

Annuities occupy an unusual position in estate planning. During the owner's lifetime, they grow tax-deferred — no capital gains, no dividend tax, no annual 1099. At death, that deferral ends abruptly. The embedded gain passes to the beneficiary as income in respect of a decedent (IRD) under IRC section 691, taxed as ordinary income. And unlike virtually every other appreciating asset, annuities are explicitly excluded from the basis step-up under IRC section 1014(b)(9)(A). The beneficiary inherits the contract's full tax liability along with its value.

How that tax liability is realized — over one year, five years, ten years, or a lifetime — depends on a set of rules that differ sharply between qualified and non-qualified annuities, and between spouse and non-spouse beneficiaries. Getting the election right within the contract's deadline window is the single most consequential tax decision the beneficiary will make.

Qualified vs. non-qualified: two entirely different rule sets

A qualified annuity sits inside a tax-advantaged retirement account — an IRA, 401(k), 403(b), or 457(b). Its distribution rules follow the retirement account rules under IRC section 401(a)(9), including the SECURE Act 2.0 ten-year rule for non-spouse beneficiaries. The entire balance is pre-tax; there is no cost basis to recover.

A non-qualified annuity is purchased with after-tax dollars outside any retirement account. Its distribution rules are governed by IRC section 72(s), which was enacted in 1984 — decades before the SECURE Act — and remains unchanged. The owner has a cost basis equal to the total premiums paid, and only the gain above basis is taxable. This distinction matters enormously: a non-qualified annuity beneficiary may still have access to a life-expectancy stretch that qualified-annuity beneficiaries lost under the SECURE Act.

Non-qualified inherited annuities: the stretch still exists

IRC section 72(s) provides the distribution framework when a non-qualified annuity owner dies before annuitization (the "annuity start date"). The default rule under section 72(s)(2) requires the entire contract value to be distributed by December 31 of the fifth year following the owner's death — the five-year rule.

But section 72(s)(2)(C) offers an alternative: if the beneficiary elects to receive distributions over their life expectancy, beginning within one year of the owner's death, the five-year rule does not apply. This is the stretch provision. It allows a 50-year-old beneficiary to spread distributions over approximately 34 years (per IRS Publication 590-B, Single Life Expectancy Table), converting what would be a compressed five-year tax hit into manageable annual payments.

The stretch election is not automatic. The beneficiary must affirmatively elect it within the time window specified by the annuity contract — typically 60 days from the date of death notification, though some carriers allow up to one year. Missing this window defaults the beneficiary to the five-year rule. This is the most common and most expensive mistake in inherited-annuity planning.

If the owner had already begun annuitization (was receiving periodic payments), the beneficiary typically continues the remaining payment stream. The payments maintain the same exclusion ratio that applied to the original owner under IRC section 72(b), and the beneficiary recognizes the same mix of taxable gain and tax-free return of basis on each payment.

The exclusion ratio: how non-qualified annuity payments are taxed

Each distribution from an inherited non-qualified annuity is split into two components under IRC section 72(b): a tax-free return of the owner's cost basis, and ordinary income on the gain. The split is determined by the exclusion ratio:

Exclusion ratio = Cost basis / Expected return

For stretch distributions, the expected return is calculated by multiplying the annual payment by the beneficiary's remaining life expectancy. If the beneficiary is 50 years old with a 34-year life expectancy and receives $18,235 per year from a contract with $280,000 in basis and $620,000 in value, the expected return is $18,235 × 34 = $620,000 (approximately). The exclusion ratio is $280,000 / $620,000 = 45.2%. Each $18,235 annual payment contains $8,242 of tax-free basis recovery and $9,993 of ordinary income.

For a lump-sum distribution, the entire gain ($620,000 − $280,000 = $340,000) is recognized as ordinary income in the year of distribution. At the 35% federal bracket plus 5% state income tax, that is approximately $136,000 in income tax — in a single year.

Qualified inherited annuities: the SECURE Act ten-year rule applies

When an annuity is held inside a traditional IRA or employer plan, the beneficiary designation on the retirement account (not the annuity contract) controls the distribution rules. For non-spouse beneficiaries who are not eligible designated beneficiaries (EDBs), the SECURE Act 2.0 ten-year rule under IRC section 401(a)(9)(H) requires the entire account balance to be distributed by December 31 of the tenth year following the owner's death.

If the original owner had already reached their required beginning date (age 73 under SECURE 2.0), the beneficiary must also take annual RMDs during the ten-year window, based on the beneficiary's single-life expectancy. If the owner died before the required beginning date, no annual RMDs are required — but the account must still be emptied by year ten.

The stretch election under IRC section 72(s)(2)(C) does not apply to qualified annuities. The retirement account rules under section 401(a)(9) override the annuity-contract rules under section 72(s). This is why the distinction between qualified and non-qualified matters so much: a non-spouse beneficiary of a non-qualified annuity may stretch over 30+ years, while the same beneficiary inheriting the same annuity contract inside an IRA is locked into 10 years.

Eligible designated beneficiaries: the exception to the ten-year rule

Five categories of beneficiaries are exempt from the ten-year rule and may still use life-expectancy stretch distributions for qualified annuities under IRC section 401(a)(9)(E)(ii):

• Surviving spouse — may also do a spousal rollover or continuation
• Minor children of the account owner — stretch ends when the child reaches the age of majority (21 under SECURE 2.0), then the 10-year clock begins
• Disabled individuals — as defined under IRC section 72(m)(7)
• Chronically ill individuals — as defined under IRC section 7702B(c)(2)
• Individuals not more than 10 years younger than the decedent — siblings, older friends, etc.

For eligible designated beneficiaries, the life-expectancy stretch remains available for qualified annuities. This means a disabled child inheriting a $400,000 IRA annuity can stretch distributions over their entire life expectancy, while a healthy 45-year-old child must empty the same account in 10 years. The classification of the beneficiary is determined at the date of the owner's death.

Spousal continuation: the most powerful option

A surviving spouse has options no other beneficiary has. For a qualified annuity inside an IRA, the spouse can roll the inherited IRA into their own IRA under IRC section 408(d)(3), effectively resetting the account as if they were the original owner. No distribution is required until the spouse reaches their own required beginning date. This is the maximum deferral available.

For a non-qualified annuity, the spouse can elect spousal continuation under IRC section 72(s)(3): the spouse steps into the deceased owner's position and continues the contract. The annuity is not treated as distributed. Tax deferral continues. The contract's cost basis, surrender schedule, and death benefit provisions remain intact. This is almost always the right choice unless the spouse needs immediate access to the full contract value.

Worked example: $620,000 non-qualified annuity and $400,000 IRA annuity

Margaret, age 78, dies in 2026. She had been receiving RMDs from her IRA but had not annuitized her non-qualified contract. Her estate includes:

• Non-qualified deferred annuity: $620,000 (cost basis $280,000, gain $340,000)
• Traditional IRA holding a fixed annuity: $400,000 (entirely pre-tax)
• Brokerage account: $800,000 (basis $450,000)
• Primary residence: $500,000
• Total gross estate: $2,320,000

Her sole beneficiary is her son David, age 52, who earns $120,000 per year. Margaret lived in New Jersey — a state with both an estate tax (repealed in 2018) and an inheritance tax (still active; lineal descendants pay 0% on the first $25,000, then 0% above — New Jersey exempts lineal descendants from inheritance tax entirely as of the 2018 reform). No state estate tax applies in New Jersey.

The federal estate is below the projected $7 million post-sunset exemption — no federal estate tax. The brokerage account and residence receive a full basis step-up under IRC section 1014. But the annuities do not.

The non-qualified annuity: stretch vs. five-year vs. lump sum

David has three options for the $620,000 non-qualified annuity:

• Lump sum: David receives $620,000 immediately. The $340,000 gain is ordinary income in 2026. Added to his $120,000 salary, his AGI jumps to $460,000 — pushing him into the 35% federal bracket. Federal tax on the gain: approximately $105,000. New Jersey income tax (10.75% on income over $1 million applies only to the NJ portion, but at $460,000 AGI the effective NJ rate on the gain is approximately 8.97%): approximately $30,500. Total tax: approximately $135,500. David nets $484,500.
• Five-year rule: David takes $124,000 per year for five years ($620,000 / 5). Each year, the exclusion ratio applies: 45.2% is tax-free basis return ($56,048), and 54.8% is ordinary income ($67,952). Federal tax on $67,952 additional income at the 24% bracket: approximately $16,309 per year. NJ tax at approximately 6.37%: $4,329. Total tax over 5 years: approximately $103,190. David nets $516,810.
• Life-expectancy stretch: David elects the stretch within 60 days. At age 52, his single-life expectancy is approximately 32.5 years (IRS Table I). Annual distribution: $620,000 / 32.5 = $19,077. The exclusion ratio allocates $8,623 to tax-free basis return and $10,454 to ordinary income. Federal tax on $10,454 at the 22% bracket: approximately $2,300 per year. NJ tax: approximately $666. Total tax over 32.5 years (nominal, undiscounted): approximately $96,400. David nets $523,600 — and his annual tax impact is negligible.

The stretch saves approximately $39,100 compared to the lump sum in total nominal tax — but the real advantage is cash-flow management: $10,454 of additional taxable income per year versus $340,000 in a single year. David stays in the 22% bracket instead of being pushed to 35%.

The IRA annuity: ten-year rule, no stretch available

David is not an eligible designated beneficiary, so the SECURE Act ten-year rule applies. Margaret had already reached her required beginning date (she was 78 and taking RMDs), so David must take annual RMDs during the ten-year window based on his single-life expectancy, with the account fully depleted by year 10.

Year 1 RMD: $400,000 / 32.5 (David's life expectancy factor) = approximately $12,308. Each year the divisor decreases by 1 and the account balance changes with investment returns. Assuming 4% annual growth in the fixed annuity, total distributions over 10 years sum to approximately $480,000. All distributions are ordinary income — there is no cost basis in a traditional IRA.

The annual RMDs of $12,000-$15,000 are manageable. But in year 10, David must withdraw the entire remaining balance — potentially $200,000 or more — creating a bracket spike. Planning the distribution pattern within the 10-year window is critical: David may want to accelerate distributions in lower-income years (job transition, sabbatical) to avoid the year-10 balloon.

The IRC section 691(c) deduction for annuities in taxable estates

When an annuity is included in a taxable estate (for federal estate tax purposes) and the beneficiary also pays income tax on the distributions, IRC section 691(c) provides a deduction for the federal estate tax attributable to the IRD. The deduction is an itemized deduction that partially offsets the double taxation.

In David's case, no federal estate tax is owed (the estate is below the exemption), so the 691(c) deduction is zero. For larger estates — say a $12 million estate with a $1 million annuity — the federal estate tax on the annuity is approximately $400,000 (40%), and the beneficiary can deduct that $400,000 against annuity distributions. This reduces the effective income tax rate on the annuity from 37% to approximately 22%. The deduction is proportional: it offsets the income tax to the extent the asset was subject to estate tax.

State inheritance and estate tax considerations

Annuities are included in the gross estate at their full contract value (or death benefit value, if higher) for both federal and state estate tax purposes. In low-exemption states, a large annuity can push an otherwise-exempt estate over the threshold:

• Massachusetts ($2 million exemption): Margaret's $2.32 million estate would be above the MA threshold if she lived there. The annuities alone account for $1.02 million of the estate. MA estate tax on a $2.32 million estate: approximately $99,600.
• Oregon ($1 million exemption): Even modest annuities can trigger the OR estate tax. A $1.5 million estate with a $400,000 annuity is well above the threshold.
• New York ($6.94 million exemption with cliff): If the estate exceeds 105% of the exemption (approximately $7.29 million), the entire estate is taxed. A large annuity pushing the estate over the cliff triggers tax on every dollar — not just the excess.

Six states impose inheritance taxes paid by the beneficiary: Iowa (repealed effective 2025), Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. For lineal descendants (children, grandchildren), most of these states provide exemptions or reduced rates. Pennsylvania is the notable exception: lineal descendants pay 4.5% on inherited assets, including annuities — on top of the income tax on the annuity gain. Maryland imposes both an estate tax and an inheritance tax, though lineal descendants are exempt from the inheritance tax.

Common mistakes that cost beneficiaries thousands

• Missing the stretch election deadline. The single most expensive error. If the beneficiary does not affirmatively elect life-expectancy distributions within the contract's specified window (often 60 days), the default is the five-year rule — or worse, some contracts default to a lump sum. Contact the insurance carrier immediately upon the owner's death.
• Confusing qualified and non-qualified rules. A non-qualified annuity beneficiary who assumes they are locked into the 10-year rule may take unnecessarily accelerated distributions. Conversely, a qualified-annuity beneficiary who assumes they have a lifetime stretch may under-distribute and face penalties.
• Taking a lump sum without modeling the tax impact. A $340,000 ordinary-income spike can trigger the 3.8% net investment income tax (NIIT) under IRC section 1411 on other investment income, increase Medicare Part B premiums via IRMAA (two-year lag), and phase out itemized deductions.
• Failing to coordinate with the overall inheritance. If David also inherits the stepped-up brokerage account, he should sell the appreciated brokerage positions (at zero capital gains) and live on those proceeds while stretching the annuity as long as possible. Selling the annuity first is exactly backwards from a tax perspective.
• Ignoring the 1035 exchange option (for non-qualified annuities). If the inherited non-qualified annuity has high fees or a poor investment menu, the beneficiary can execute a tax-free 1035 exchange under IRC section 1035(a)(3) into a lower-cost annuity — preserving the stretch and the basis. This does not work for qualified annuities inside an IRA; those follow IRA-to-IRA transfer rules.

Key takeaways

• Annuities never receive a basis step-up at death under IRC section 1014(b)(9)(A). The embedded gain passes to the beneficiary as IRD under IRC section 691, taxed as ordinary income — making annuities among the least tax-efficient assets to inherit.
• Non-qualified annuities follow IRC section 72(s), which still permits life-expectancy stretch distributions for non-spouse beneficiaries who elect within the contract's deadline window. This stretch was not affected by the SECURE Act.
• Qualified annuities (inside IRAs or employer plans) follow retirement-account rules under IRC section 401(a)(9). Non-spouse beneficiaries face the SECURE Act 2.0 ten-year rule — no stretch available unless the beneficiary qualifies as an eligible designated beneficiary (surviving spouse, minor child, disabled, chronically ill, or within 10 years of the decedent's age).
• Surviving spouses have the most powerful option: spousal continuation for non-qualified annuities (contract continues tax-deferred) or spousal rollover for qualified annuities (IRA becomes the spouse's own).
• Missing the stretch election deadline on a non-qualified annuity defaults the beneficiary to the five-year rule — potentially the most expensive single mistake in inherited-annuity planning.
• For estates above the federal exemption, the IRC section 691(c) deduction partially offsets the double taxation (estate tax plus income tax) on annuity proceeds. For estates below the exemption, no 691(c) deduction is available.
• Coordinate annuity distributions with other inherited assets: spend down stepped-up assets first (zero capital gains tax) and stretch the annuity as long as possible to minimize the ordinary-income impact.