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 (IRAs or 401(k) rollovers), a non-qualified annuity was funded with after-tax dollars and has its own set of beneficiary rules and tax treatments. This guide explains how inherited non-qualified annuities work, how the gain is taxed, and practical strategies to minimize the bill and maximize what stays in your family. For a quick foundation, you can skim our primer on what a non-qualified annuity is and then come back here for beneficiary-specific guidance.

What makes an inherited non-qualified annuity different?

With non-qualified contracts, the owner already paid tax on the original contribution. What’s taxable to the beneficiary is generally the interest gain that accumulated inside the contract. That’s very different from a qualified account where the entire withdrawal is usually taxable. If you’re comparing the two worlds, this overview of how annuities are taxed in retirement helps set expectations about ordinary income vs. basis recovery.

How taxes are calculated: LIFO and the exclusion ratio

Most deferred annuities use LIFO (Last-In, First-Out) for distributions prior to annuitization—meaning gains come out first and are taxed as ordinary income until all gain is withdrawn. If you annuitize (turn the value into a payment stream), taxes are determined by the exclusion ratio, which spreads basis recovery across payments so only a portion of each check is taxable. If you want a deeper dive before choosing a payout path, read our focused explainer on the annuity exclusion ratio in plain English.

Beneficiary options for non-qualified annuities

• Lump-sum distribution: Simple, immediate access; all gain is taxed in the year received. Good for small contracts or urgent needs.
• Systematic withdrawals: Take monthly or annual payments; gain is taxed as received (LIFO until the gain is exhausted).
• Annuitization to a fixed payment stream: Converts the contract to lifetime or period-certain income with an exclusion ratio that blends basis and gain.
• Spousal continuation (when available): Some contracts allow a spouse to step in as owner and continue deferral. Terms vary by contract.

There are no RMDs on non-qualified annuities. That said, timelines in the contract (such as “five-year rules” after death) can apply—check your certificate or let us review it with you.

Case study: Two payout paths, two tax results

Scenario: Maria inherits a $190,000 non-qualified annuity. Her mother paid $120,000 in total premium, so there’s $70,000 of gain. Maria earns a high salary this year but expects a career break next year.

• Path A — Lump sum this year: Maria takes $190,000 now. The entire $70,000 gain is taxed in a peak-income year—costly.
• Path B — Two-year strategy: Maria withdraws $15,000 of gain this year and the remaining $55,000 next year when her income is lower—shrinking total taxes.

Takeaway: thoughtful timing can materially change the after-tax value. If you prefer guaranteed checks, run side-by-side quotes for current income annuity rates to see annuitization trade-offs with exclusion-ratio taxation.

Should you consider a 1035 exchange first?

Beneficiaries sometimes move the inherited contract to a new annuity using a Section 1035 exchange to improve fees or features while preserving tax deferral. Rules are strict (and different for beneficiaries vs. original owners), so confirm eligibility and timelines. For mechanics and pitfalls, review how 1035 exchanges work in annuity planning before you act.

When annuitization makes sense (and when it doesn’t)

Pros: predictable cash flow, potential tax smoothing via the exclusion ratio, and guardrails for spenders. Cons: reduced flexibility, generally irrevocable, and the need to choose period-certain or lifetime options carefully. If you’re weighing income features across products, our overview of key annuity benefits for retirees can help frame the decision.

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Practical checklist for beneficiaries

• Confirm contract type (non-qualified) and total premium paid to establish cost basis.
• Ask the carrier for a death-claim packet, cost-basis confirmation, and available payout options.
• Model taxes under systematic withdrawals vs. annuitization with exclusion ratio.
• Evaluate whether a 1035 exchange could improve features without triggering taxes.
• Coordinate with other income sources to avoid bracket creep and Medicare surcharges.
• Set a written distribution plan and calendar key deadlines in the contract.

If you’re still building your knowledge, this short refresher on what a fixed annuity is can be helpful context as you evaluate choices.