Inheriting a non-qualified annuity can feel complicated—especially when you’re trying to honor a loved one’s wishes while avoiding unnecessary taxes. Unlike inherited qualified annuities (such as IRA or 401(k) rollover annuities), a non-qualified annuity was funded with after-tax dollars. That one detail changes everything: the beneficiary generally owes tax on the gain (the growth inside the annuity), not on the original premium. This guide walks you through inherited non-qualified annuity rules, how taxation works in the real world, beneficiary payout options, and practical strategies to reduce the tax hit and keep more of the inheritance in your family.

At Diversified Insurance Brokers, we help beneficiaries and retirees evaluate annuity decisions with a focus on clarity, taxes, and long-term outcomes. We work with 75+ top-rated carriers, and we regularly review inherited contracts to identify what matters most: cost basis confirmation, the gain amount, contract-specific death benefit rules, and your best payout options based on income needs and tax brackets. If you want a quick foundation before you go deeper, start with what a non-qualified annuity is, then come back here for beneficiary-specific planning.

Inherited Non-Qualified Annuity: The Simple Definition

An inherited non-qualified annuity is an annuity you receive as a beneficiary that was originally funded with after-tax dollars. The owner paid tax on the premium when they earned it (salary, savings, etc.), then deposited that money into the annuity. Over time, the annuity may have grown through credited interest (fixed), index-linked crediting (fixed indexed), or other accumulation methods. When the original owner dies, you inherit the contract’s value and must choose how you want to receive it—often through the carrier’s death-claim process and beneficiary distribution options.

Here’s the key tax concept: because the premium was after-tax, the premium is considered the contract’s cost basis. That cost basis is generally not taxed again. What is taxable to the beneficiary is typically the gain—the growth above the original basis. This differs from a qualified annuity or IRA-based annuity, where much (or all) of distributions may be taxable as ordinary income because the contributions were pre-tax. If you want the big-picture view of how annuity taxation works across different situations, this guide helps set expectations: How annuities are taxed in retirement.

What Makes an Inherited Non-Qualified Annuity Different From an Inherited Qualified Annuity?

Non-qualified annuities are funded with after-tax dollars. Qualified annuities are funded inside qualified accounts (IRAs, 401(k)s, etc.) that typically involve pre-tax contributions. From a beneficiary’s standpoint, the non-qualified world is often more flexible in how “basis” is treated—but it can still create a major tax bill if the gain is large and the payout is handled poorly.

With an inherited non-qualified contract, the insurer will generally confirm two numbers during the death-claim process: the current value and the cost basis (total premiums paid, sometimes adjusted by withdrawals). The difference between those numbers is the gain. That gain is usually taxable to the beneficiary as ordinary income as it is distributed. That’s one reason beneficiaries are often surprised—annuities are not typically taxed at capital gains rates. If you’re deciding between annuity income strategies versus other retirement income tools, it can also help to review key annuity benefits and how they compare to other planning methods.

Step One After Inheriting: Identify the Contract Type and the “Gain”

The best first step is not choosing a payout option—it’s confirming what you actually inherited. Many beneficiaries only know that “it’s an annuity,” but the details matter. Ask the carrier for the death-claim packet and request a written statement showing:

• The current account value as of date of death (and/or current date)
• The total premium paid (cost basis)
• The taxable gain amount (value minus basis)
• Whether the contract is deferred or already annuitized
• Available beneficiary payout options and any required timelines

Why does this matter? Because the payout method you choose can change the timing of taxation, and timing is often the biggest lever you have as a beneficiary. If you pull the entire gain into one tax year, you may push yourself into a higher marginal bracket, increase tax on Social Security (if applicable), and potentially create Medicare IRMAA issues in later years. Even if you do not have RMDs on non-qualified contracts, many contracts have death benefit timing provisions that require distribution within a certain time window. Those rules are contract-driven, so you want to read them carefully or have a professional review them with you.

How Taxes Are Calculated: LIFO and the Exclusion Ratio

Inherited non-qualified annuity taxation usually follows two major frameworks depending on the distribution method: LIFO taxation for most withdrawals and the exclusion ratio for annuitized payouts. Understanding this difference is essential because it impacts how quickly you recognize taxable income.

LIFO (Last-In, First-Out) is common for deferred annuities that are not annuitized. It generally means that gains come out first. So if you inherit a contract with $70,000 of gain, the first dollars you withdraw are typically treated as taxable ordinary income until that $70,000 gain is fully distributed. After the gain has been distributed, additional withdrawals are usually treated as a return of basis and are generally not taxable.

The exclusion ratio applies when you annuitize—meaning you convert the contract into a stream of payments over a set period or lifetime. Under annuitization, each payment is treated as a blend of taxable gain and non-taxable return of basis. This spreads the basis recovery across the payment stream, often creating smoother taxation. If you want a deeper dive before choosing a payout path, review the annuity exclusion ratio explained.

There is no universally “best” choice between these two methods. LIFO can be efficient if you need a short-term payout and can manage taxes. The exclusion ratio can be appealing if you prefer predictable payments and want to spread taxation across time. Your decision should be grounded in your cash-flow needs, tax bracket, other income sources, and how important liquidity is to you.

Beneficiary Options for Inherited Non-Qualified Annuities

Most inherited non-qualified annuities offer a menu of beneficiary payout options. What’s available depends on the carrier and the specific contract, but the common options include:

1) Lump-sum distribution. This is the simplest option: you take the full value now. It can be appropriate for smaller contracts, urgent needs, or when the gain is minimal. But it often creates the largest tax spike because all gain is taxed in the year you receive it. If the contract has a large gain and you already have high income, this can be the most expensive route.

2) Systematic withdrawals (stretch-like payments). Many contracts allow beneficiaries to take scheduled withdrawals monthly or annually. This often gives you a practical way to control how quickly you recognize income. Under LIFO, the gain is still typically taxed first, but spreading withdrawals across years may keep you out of higher brackets and reduce the “stacking” effect that happens when income spikes.

3) Annuitization to a fixed payment stream. You can convert the value into a period-certain income stream or, in some cases, a lifetime income stream. Under annuitization, the exclusion ratio applies. This can be useful for beneficiaries who want a stable check and want to blend taxable and non-taxable dollars over time. It is also a way to “force” a distribution plan, which some families prefer to reduce the temptation of overspending the inheritance quickly.

4) Spousal continuation (when available). If the beneficiary is the spouse, some contracts allow the spouse to “step in” and continue the annuity as the new owner. This can preserve tax deferral and allow the spouse to treat the contract as their own. Terms and eligibility vary, so it’s important to review the contract language and carrier rules.

One crucial note: beneficiaries often assume there are “RMDs” like there are for inherited IRAs. For non-qualified annuities, you generally do not have federal RMD rules in the same way. However, you may have death benefit timing provisions—sometimes referred to informally as “five-year rules”—that require distribution within a certain period. The contract and carrier will define those deadlines, so don’t assume you can defer forever.

Choosing the Best Payout Option: A Practical Decision Framework

When beneficiaries ask “what’s the best option,” what they often mean is “what will keep the most money in my pocket after taxes?” That’s a fair question, but it’s incomplete. The best strategy usually balances four competing priorities: taxes, liquidity, income stability, and personal discipline.

Taxes: If the gain is large, taxes become the main lever. Many beneficiaries improve outcomes simply by avoiding an unnecessary lump sum. Spreading gain across years can reduce the marginal rate applied to the gain and avoid causing other tax side effects.

Liquidity: If you need access to cash for a home payoff, education, medical expenses, or a major transition, that may justify a faster payout. But even then, you may be able to structure it as “partial lump sum” plus staged withdrawals to avoid maxing out taxes in one year.

Income stability: If the inheritance is replacing a spouse’s income, supporting retirement cash flow, or functioning as a safety net, an income stream can be attractive. If you’re considering guaranteed payments, it can help to compare options using a rates benchmark, such as current income annuity rates, to understand what today’s payout structures look like.

Behavioral discipline: Some beneficiaries want flexibility. Others want guardrails. An annuitized payment stream can provide structure and prevent an inheritance from disappearing quickly. The right answer depends on the individual and the family dynamics.

Case Study: Two Payout Paths, Two Tax Outcomes

Scenario: Maria inherits a $190,000 non-qualified annuity. Her mother paid $120,000 in total premium, so there is $70,000 of gain. Maria earns a high salary this year but expects a career break next year. She’s deciding whether to cash out or spread the withdrawals.

Path A — Lump sum this year: Maria takes the full $190,000 now. The gain portion ($70,000) is taxable as ordinary income in a year when her income is already high. That added income can push her into a higher bracket and create tax “spillover.” The inheritance is still meaningful, but the after-tax value is lower than it needs to be.

Path B — Two-year strategy: Maria takes a smaller withdrawal this year that recognizes only part of the gain, then takes the remainder next year when her income is lower. The overall tax paid on the gain may be lower because the marginal rate applied to much of the gain is reduced. In addition, spreading withdrawals can help avoid other side effects that can happen when taxable income spikes in a single year.

Takeaway: Timing matters. For many beneficiaries, “tax planning” isn’t complicated—it’s simply choosing a distribution schedule that matches their income profile. If you’re comparing options and want to see what guaranteed income could look like, you can use the calculator below to model lifetime income scenarios and compare them to systematic withdrawals.

Lifetime Income Calculator

Should You Consider a 1035 Exchange First?

Sometimes beneficiaries ask whether they can “move” the inherited annuity to a different carrier before taking withdrawals. In certain cases, an inherited contract may be eligible for an exchange under Section 1035, which can preserve tax deferral while allowing changes to fees, features, income options, or crediting methods. However, beneficiary exchanges are more restrictive than owner exchanges, and eligibility depends heavily on how the contract is titled and what the carrier allows.

Why might a beneficiary explore a 1035 exchange? Because inherited contracts are not always ideal. The annuity might have outdated features, poor renewal rates, limited income options, or unnecessary fees. If you can exchange into a structure that better aligns with your goals, you may improve long-term outcomes. But this is not something to do casually. Rules are strict, timing matters, and the wrong move can accidentally trigger taxation. For mechanics and pitfalls, review how 1035 exchanges work in annuity planning before you act.

A practical approach is to treat the exchange decision as a comparison: (1) keep the contract and distribute it, (2) annuitize the inherited contract if permitted, or (3) explore an exchange if allowed to improve the payout structure. Not every inherited annuity should be exchanged, but in the right situation—especially when the goal is long-term income—it can be worth evaluating.

When Annuitization Makes Sense (And When It Doesn’t)

Annuitization is one of the most misunderstood tools in annuity planning. Beneficiaries sometimes fear it because it can be irrevocable. That fear is valid—once you annuitize, you’re typically converting the annuity’s value into a payment stream and giving up access to the lump sum. But annuitization can also provide meaningful benefits when it matches the situation.

When annuitization can make sense: If you want a predictable income stream, you want to spread taxes via the exclusion ratio, and you don’t need full liquidity, annuitization can be a strong fit. It also creates guardrails: it can prevent overspending and provide a disciplined structure. For some beneficiaries, that structure is a feature, not a drawback.

When annuitization may not make sense: If you need access to principal, expect a major purchase, want to invest elsewhere, or dislike irrevocable decisions, systematic withdrawals can be preferable. Another consideration is the specific pricing of the inherited contract’s annuitization options—some contracts offer stronger payout factors than others. That’s why comparing current market payout options can help you evaluate whether annuitization is attractive relative to alternatives.

If you’re weighing income features across products and want a wider context for retirement income planning, this resource can help frame the decision: key annuity benefits for retirees.

The “Hidden” Issue: Tax Bracket Creep and Medicare IRMAA

Inherited annuity decisions often become expensive when beneficiaries focus only on “how much can I withdraw” rather than “how much taxable income will this add.” Even though non-qualified annuities do not follow IRA RMD rules, they can still create a large tax problem if the gain is distributed in a compressed time frame.

For retirees, a common surprise is Medicare IRMAA—higher premiums triggered by higher modified adjusted gross income. If an inherited annuity distribution pushes income higher in one year, it can create higher Medicare premiums later. Even if you are not yet on Medicare, understanding that these income cliffs exist can influence whether you want a lump sum or a staged approach.

Similarly, a gain-heavy inherited annuity can affect taxation of Social Security benefits if you are receiving them. This is another reason why many beneficiaries prefer a distribution plan that spreads gain over time rather than pulling it all into one year.

Practical Checklist for Beneficiaries

When you inherit a non-qualified annuity, the goal is to move from “confusion” to a clear plan. Use this checklist to stay organized and avoid common mistakes:

• Confirm contract type: Verify it is non-qualified (after-tax funded), not qualified.
• Confirm cost basis: Obtain written confirmation of total premiums paid and any adjustments.
• Identify the gain: Calculate the taxable gain amount and verify it with the carrier.
• Get the payout menu: Request beneficiary distribution options and any timeline requirements.
• Model taxes: Compare lump sum vs. staged withdrawals vs. annuitization with the exclusion ratio.
• Coordinate with income sources: Consider salary, retirement income, Social Security, and timing of major events.
• Check exchange eligibility: If improving features matters, explore whether a 1035 exchange is allowed.
• Put it in writing: Create a written distribution plan with a calendar for deadlines and annual review dates.

If you’re still building your annuity knowledge overall, these two pages can help provide context as you evaluate inherited choices: what a fixed annuity is and how annuities are taxed.