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When you first learn you’re inheriting an annuity, it often feels like a financial blessing. However, reality kicks in fast, with taxes waiting around the corner. While you can’t dodge them entirely, there are ways to ease the impact, and the sooner you understand your options, the better.

Why Inherited Annuities Get Taxed in the First Place

Before diving into strategies, let’s understand why taxes are applied. An annuity is a contract that pays out income, often used to fund retirement. If the original owner passes away, the payments don’t necessarily stop — they can continue to a named beneficiary.

But here’s the catch: the IRS wants its share. The rules depend on how the annuity was funded. If it was bought with pre-tax dollars (a qualified annuity, often inside a 401(k) or IRA), the entire payout is taxable as income when received. If it was bought with after-tax dollars (a non-qualified annuity), only the earnings portion — not the original investment — is taxed. Still, this tax treatment can shrink what you receive if you’re not prepared.

What Happens When You Inherit an Annuity?

If you’re the spouse, the process is relatively gentle. You can often continue the contract and delay taxes until you start taking payments. But if you’re a non-spouse — say, you inherit an annuity from a parent — you face choices that shape your tax bill.

Here’s where things get practical. The IRS generally gives non-spouse beneficiaries four options to take the money:

Lump sum: You cash out all at once. You’ll pay taxes immediately on the taxable part, which can mean a large tax bill in a single year.

Five-year rule: You withdraw all funds within five years, paying taxes as you take the money. It spreads the tax burden over a few years rather than one.

Non-qualified stretch: Payments are stretched over your expected lifetime, indicating smaller annual payouts and lower yearly taxes.

Periodic payments: Similar to the stretch option, but payments aren’t strictly tied to your life expectancy.

Choosing between speed and tax efficiency is the key trade-off here. A lump sum and five-year rule get you the money faster but at the cost of a bigger tax hit. Stretch and periodic payments keep taxes lower each year but mean waiting longer to see the full inheritance.

Can You Avoid Taxes Completely?

Not really, but you can defer them or reduce their impact.

If you’re the surviving spouse, your best move is often to keep the annuity going as it was. This keeps the tax deferral alive until you need the income.

If you’re a non-spouse, consider the non-qualified stretch or periodic payments. By taking smaller distributions over many years, you can avoid bumping into a higher tax bracket that comes with big, one-time payouts.

There’s also something called a 1035 exchange, where you swap the inherited annuity for another one with better terms — say, lower fees or more flexible payout options. This won’t erase taxes, but it can improve what you get. The swap must stay within the same tax status; you can’t switch from a qualified to a non-qualified annuity to avoid taxes.

And if the annuity was inside a retirement account, such as an IRA, there may be an option to roll it into an inherited IRA, preserving tax benefits. Note that if the account is qualified (pre-tax dollars), most non-spouse heirs must now withdraw all funds within 10 years due to the SECURE Act. The stretch option is generally no longer available for inherited IRAs unless you're an eligible designated beneficiary. However, this rule doesn’t apply to non-qualified annuities, which retain more flexible distribution options.

Bottom Line

While you can’t skip taxes entirely on an inherited annuity, you can manage them wisely. Understanding how payouts work and how they’re taxed — combined with strategies like stretching payments or using a 1035 exchange — can help you keep more of what you inherit.