Inherited Non-Qualified Annuity Distribution Rules

An inherited non-qualified annuity is an insurance contract, funded with after-tax money, that passes to a beneficiary upon the owner’s death. This inheritance triggers specific rules governing how the beneficiary can access the funds and how those funds will be taxed. The choices a beneficiary makes determine not only when they receive the money but also the total tax impact. The beneficiary’s relationship to the original owner—whether they are a spouse or a non-spouse—is the primary factor in the distribution options they can select.

Core Tax Principles of Inherited Non-Qualified Annuities

The taxation of distributions from an inherited non-qualified annuity depends on its cost basis and gain. The cost basis is the total amount of after-tax premiums the original owner paid, which can be returned to the beneficiary tax-free. The gain represents the accumulated interest and investment growth, which is subject to ordinary income tax. Inherited non-qualified annuities do not receive a “step-up” in basis upon death, so the original cost basis carries over to the beneficiary.

Distributions are taxed according to the Last-In, First-Out (LIFO) method. This means the first dollars withdrawn are considered the taxable earnings. Only after all gains have been distributed can the beneficiary begin to receive the original, tax-free principal.

For example, consider an inherited annuity valued at $200,000 with a cost basis of $120,000. The remaining $80,000 is the taxable gain. If the beneficiary takes a distribution of $50,000, the entire amount is treated as ordinary income. Subsequent withdrawals will also be fully taxable until the entire $80,000 of earnings has been paid out. After the gains are depleted, any further distributions are a tax-free return of the $120,000 cost basis.

Distribution Options for a Spousal Beneficiary

A surviving spouse who is the sole primary beneficiary of a non-qualified annuity has a unique option not available to others: Spousal Continuation. This provision allows the spouse to become the new owner of the contract and treat the annuity as their own, with all original terms remaining in place. The primary advantage is continued tax deferral, allowing the annuity’s value to grow without immediate tax consequences until the new spousal owner takes withdrawals. This allows the spouse to integrate the annuity into their own long-term financial planning.

To execute a spousal continuation, the surviving spouse must be named as the 100% primary beneficiary. If the spouse is one of several primary beneficiaries, this option is generally eliminated. Continuation also allows the spouse to name their own beneficiaries for any remaining funds.

While spousal continuation is an advantage, a surviving spouse is not required to choose it. They also have access to the same distribution options available to non-spouse beneficiaries, providing flexibility if immediate or structured income is preferred.

Distribution Options for a Non-Spouse Beneficiary

Beneficiaries who are not the surviving spouse, such as a child, sibling, or trust, face a different set of distribution rules. They cannot continue the contract as their own and must choose a method to distribute the inherited funds. The options fall into three categories, each with distinct timelines and tax implications.

The 5-Year Rule

The 5-Year Rule is the default distribution method for many inherited non-qualified annuities if another option is not actively chosen. This rule requires the beneficiary to withdraw the entire balance of the annuity by the end of the fifth calendar year following the owner’s death. For instance, if the owner passed away in 2025, the beneficiary would have until December 31, 2030, to fully liquidate the account.

This option offers flexibility within the five-year window. The beneficiary can take the entire amount in a single lump sum, withdraw smaller amounts at their discretion, or wait until the final year to take the full balance, as there are no annual required minimum distributions (RMDs).

Life Expectancy Payouts

This option allows a beneficiary to receive payments from the inherited annuity over their own life expectancy. This method is advantageous for spreading out the tax impact over many years while continuing tax-deferred growth on the remaining assets. The election to use this method must be made within one year of the owner’s death to avoid defaulting to the 5-Year Rule.

To calculate the annual required payment, the beneficiary uses the IRS’s Single Life Expectancy Table. The required distribution for a given year is determined by dividing the annuity’s account balance as of December 31 of the prior year by the beneficiary’s life expectancy factor. This option is available only to individual beneficiaries, not to entities like trusts or charities.

Annuitization

A third option is to annuitize the inherited death benefit. This involves converting the lump-sum value of the annuity into a series of guaranteed, regular payments from the insurance company. These payments can be structured for a fixed period or for the beneficiary’s life, but the schedule cannot extend beyond the beneficiary’s life expectancy.

Unlike the life expectancy payout method, annuitization provides a fixed and predictable income stream, and the process must begin within one year of the owner’s death. A key distinction is the tax treatment, as each payment is split into a tax-free return of principal and a taxable portion of earnings, which can be more favorable than the LIFO treatment of other methods.

Making Your Distribution Election

Once you understand the available distribution options, you must formally notify the insurance company of your choice. This process requires specific documentation and adherence to strict deadlines. Failing to act in a timely manner can result in the insurance company defaulting your choice to the 5-Year Rule.

Required Documentation

Before the insurance company can process a claim, a beneficiary must provide essential documents. The primary document is a certified copy of the original annuity owner’s death certificate, as photocopies are not accepted. This official record verifies the death and initiates the claims process.

You will also need to provide your own personal identification. This includes your full legal name, Social Security number, and a copy of a valid government-issued photo ID, such as a driver’s license or passport, for identity verification and tax reporting.

The Beneficiary Claim Form

The main component of this process is the beneficiary claim form, obtained from the insurance company that issued the annuity. This document will ask for the deceased owner’s contract information, your personal details, and your formal distribution election. The form will have a dedicated section where you must select your chosen payout method, such as “Lump Sum Distribution,” “5-Year Rule,” or “Life Expectancy Payments.” Once submitted, this choice is often irrevocable, so be certain of your selection before completing the paperwork.