When you inherit an annuity, the primary question on your mind is often a practical one: do beneficiaries of an annuity pay taxes? The short answer is yes, but the amount you owe depends heavily on how the original owner funded the account and how you choose to receive the money.

Unlike life insurance proceeds, which are typically tax-free to the recipient, annuity death benefits are often subject to ordinary income tax. Understanding the nuances of "qualified" versus "non-qualified" contracts can help you avoid a massive and unexpected tax bill.

1. How Funding Affects Your Tax Bill

The taxability of an inherited annuity is determined by whether the money used to purchase it was already taxed. This distinction is the most important factor in your financial planning.

Qualified Annuities

A qualified annuity is one held within a tax-advantaged retirement account, such as a traditional IRA or 401(k). Because the original owner used pre-tax dollars to fund the account, the IRS has not yet collected income tax on that money. As a beneficiary, every dollar you withdraw is taxed as ordinary income at your current tax rate.

Non-Qualified Annuities

A non-qualified annuity is purchased with "after-tax" dollars—money from a standard savings or brokerage account. For these contracts, you only owe taxes on the earnings (the growth). The "principal" (the original amount invested) is returned to you tax-free because the original owner already paid taxes on it.

2. Payout Options and Their Tax Consequences

How you choose to receive the funds can significantly impact your tax bracket. The IRS generally follows a "Last-In, First-Out" (LIFO) rule for withdrawals, meaning the taxable earnings are considered the first dollars coming out of the contract.

  • Lump-Sum Distribution: You receive the entire death benefit at once. This is often the least tax-efficient method, as a large payout can push you into a higher tax bracket for that year, causing you to pay a higher percentage in taxes than necessary.

  • The Five-Year Rule: This requires you to empty the account within five years of the owner's death. You can take the money in several chunks, spreading the tax liability over multiple years to stay in a lower tax bracket.

  • Annuitization (The Stretch): You can convert the balance into a stream of payments over your life expectancy. For non-qualified annuities, an exclusion ratio is used to determine what portion of each check is tax-free principal and what is taxable gain.

3. Special Rules for Spouses

If you are the surviving spouse of the annuity owner, you have a unique advantage called Spousal Continuation. This allows you to step into the shoes of the original owner, taking over the contract as if it were your own.

By choosing this route, you continue the tax-deferred growth and do not owe immediate taxes upon the original owner's death. Non-spousal beneficiaries, such as children or siblings, do not have this option and must generally begin taking distributions—and paying the associated taxes—within the timelines dictated by the SECURE Act.

4. Avoiding Penalties and Other Costs

While income tax is the main concern, there is one common "penalty" you likely won't have to worry about. Typically, the IRS imposes a 10% penalty on annuity withdrawals made before age 59½. However, this penalty is generally waived for beneficiaries inheriting an annuity, regardless of their age.

You should also check for state-specific rules. For example, some states levy an inheritance tax which is paid by the person receiving the money, separate from federal income tax obligations. Consulting with a tax professional can help you navigate these state-level nuances and ensure you select the payout method that preserves the most of your inheritance.