Inherited Annuity Taxes 2026: 5-Year Rule, Payouts, Form 1099-R
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Quick Answer
As of October 23, 2026, an heir who inherits a nonqualified annuity gets no step-up in basis and pays ordinary income tax only on the gain, and if the owner died before payments started the whole contract must be paid out within 5 years of the death unless a person named as beneficiary takes it over life expectancy starting within 1 year, or a spouse takes the contract over. Section 1014(b)(9)(A) keeps annuities “described in section 72” out of the step-up, and IRS Publication 575 says a deferred-annuity death benefit above the decedent’s cost is income in respect of a decedent. On our example, a $500,000 contract with a $200,000 cost leaves a $300,000 gain: taken as a lump sum by a single heir with $120,000 of other taxable income it costs about $103,343 in 2026 federal tax (34.4% of the gain), and taken as $60,000 of gain a year over five years about $72,000 (24.0%), because the lump sum reaches the 35% bracket and the 3.8% net investment income tax (our arithmetic). The 2025 law (Public Law 119-21) did not change sections 72, 691 or 1014. An annuity inside an IRA is different: section 72(s) does not apply to it, and the 10-year rule does. This is analysis of public documents, not investment, legal or tax advice.
Key Takeaways
- Gain first, no step-up. 26 U.S.C. 1014(b)(9)(A) says the date-of-death basis rule does not apply to “annuities described in section 72,” and 1014(c) excludes any right to income in respect of a decedent. Under 72(e)(2)(B) and (3)(A), what you take out before payments are annuitized is income until the contract’s gain is used up, and only then a tax-free return of the owner’s cost.
- The 5-year clock runs from the date of death, not from December 31. 72(s)(1)(B) requires the contract to provide that, if the holder dies before the annuity starting date, the entire interest is paid within 5 years after the death. Two exits in 72(s)(2) and (3): a designated individual beneficiary taking payments over life (or a period not beyond life expectancy) starting within 1 year of death, and a surviving spouse, who is treated as the holder.
- No regulation fills in 72(s). Our October 23, 2026 search of eCFR Title 26 for “section 72(s)” returned one hit, a foreign-currency regulation (1.987-1) that only lists 72(s) among other statutes. So which life-expectancy table applies, and how a carrier sets the first payment date, comes from the contract and the carrier, not from a Treasury rule we could read.
- A trap in the paperwork: Rev. Rul. 2007-24 holds that a check from an insurer under a nonqualified annuity, endorsed over to a second insurer, is not a section 1035 exchange and is taxable under 72(e). Moving an inherited contract needs a direct transfer between insurers, not a check to you.
- On a $500,000 contract with a $200,000 cost, a single heir with $120,000 of other 2026 taxable income pays about $103,343 on a lump sum (income tax $94,371 plus $8,972 NIIT) and about $72,000 spreading the $300,000 gain at $60,000 a year for five years, then taking the $200,000 cost last and tax-free. The $31,343 gap is bracket management, not a loophole (our arithmetic, assuming no growth).
- 2025 law check: Public Law 119-21 raised the basic exclusion amount to $15,000,000 for deaths after December 31, 2025 (section 70106) and rewrote section 68 so that itemized deductions are cut by 2/37 for taxpayers in the 37% bracket from 2026 (section 70111). Neither changes the annuity rules, but both touch the one deduction an heir may have, the section 691(c) estate tax deduction.
- Annuities held in an IRA or 401(k) are outside 72(s) (72(s)(5)). Under 401(a)(9)(H) as amended in 2019, a designated beneficiary who is not an eligible designated beneficiary must empty the account within 10 years; Pub. 590-B’s example is an owner who died in 2025, with the IRA emptied by December 31, 2035. Our page on the [inherited IRA 10-year rule](/articles/inherited-ira-10-year-rule-annual-rmd-real-estate-2026) has the annual-withdrawal rule for owners who had reached their required beginning date.
CSV · 70 rows
Inherited annuity tax rules, 2026: Code, IRS publications, 2025 law check and a $300,000-gain example
70 rows: 72(s) death-of-holder rules, 72(e) gain-first, 1014 and 691, 401(a)(9) for IRA annuities, Form 1099-R codes, the P.L. 119-21 check, the 2026 brackets used, and our arithmetic for three payout paths.
What the Code says, paragraph by paragraph
Everything in this table is in the statute or an IRS document we saved on October 23, 2026. The first seven rows are all of section 72(s), the death-of-holder rule.
| Rule | What the source says | Source |
|---|---|---|
| Death after payments started | The contract must provide that “the remaining portion of such interest will be distributed at least as rapidly as under the method of distributions being used as of the date of his death” | 26 U.S.C. 72(s)(1)(A) |
| Death before payments started | “the entire interest in such contract will be distributed within 5 years after the death of such holder” | 26 U.S.C. 72(s)(1)(B) |
| Life-expectancy exception | A portion payable to a designated beneficiary over the beneficiary’s life, or a period not beyond life expectancy, counts as distributed when payments begin if they begin “not later than 1 year after the date of the holder’s death” | 26 U.S.C. 72(s)(2) |
| Surviving spouse | Paragraphs (1) and (2) apply “by treating such spouse as the holder of such contract” | 26 U.S.C. 72(s)(3) |
| Who is a designated beneficiary | “any individual designated a beneficiary by the holder of the contract” (a trust or estate is not an individual) | 26 U.S.C. 72(s)(4) |
| Non-individual owner | If the holder is not an individual, the primary annuitant is treated as the holder, and a change of primary annuitant is treated as the holder’s death | 26 U.S.C. 72(s)(6), (7) |
| Contracts outside the rule | Section 72(s) does not apply to plans under 401(a) or 403(a), 403(b) annuities, an “individual retirement annuity or provided under an individual retirement account or annuity,” or a qualified funding asset | 26 U.S.C. 72(s)(5) |
| Gain comes out first | An amount received before the annuity starting date is included in gross income “to the extent allocable to income on the contract” and is not included “to the extent allocable to the investment in the contract” | 26 U.S.C. 72(e)(2)(B) |
| How income is measured | Allocable to income to the extent the amount does not exceed the cash value immediately before it is received over the investment in the contract | 26 U.S.C. 72(e)(3)(A) |
| No 10% penalty at death | The 10% additional tax does not apply to a distribution “made on or after the death of the holder” | 26 U.S.C. 72(q)(2)(B) |
| No step-up | The date-of-death basis rule “shall not apply to” “annuities described in section 72” | 26 U.S.C. 1014(b)(9)(A) |
| Who reports the income | Income in respect of a decedent is included by “the person who, by reason of the death of the decedent, acquires the right to receive the amount” | 26 U.S.C. 691(a)(1)(B) |
| Death benefit under a deferred annuity | If the decedent died before the annuity starting date, the amount you receive, in a lump sum or as periodic payments, “in excess of the decedent’s cost is included in your gross income as income in respect of a decedent” | IRS Pub. 575 (2025) |
| Single-sum variable annuity death benefit | “generally taxable only to the extent it is more than the unrecovered cost of the contract” | IRS Pub. 575 (2025) |
Source: 26 U.S.C. 72, 691 and 1014 (Cornell Legal Information Institute, read October 23, 2026) and IRS Publication 575 (2025).
Two things the statute leaves to the contract. First, the word is “holder”: whether the contract is triggered by the owner’s death or the annuitant’s depends on how it is written, and the Code only tells you what happens when the holder is not a person (the primary annuitant is the stand-in). Second, 72(s)(2) refers to life expectancy “in accordance with regulations,” and we found no regulation under 72(s) (see the second takeaway). Read the contract’s death-benefit section before choosing.
The four ways out, and what each does to the tax
| Option | Who can use it | Deadline | How it is taxed (our reading of the Code) | Source |
|---|---|---|---|---|
| Lump sum | Any beneficiary | No deadline inside 5 years | The whole gain in one year as ordinary income; cost comes back tax-free. Also net investment income for the 3.8% tax above $200,000 (unmarried) or $250,000 (joint) of modified AGI | 72(e); 1411(a), (b), (c)(1)(A)(i) |
| 5-year window | Any beneficiary, and the only choice for an estate or trust | Entire interest within 5 years after the date of death | You pick when to withdraw. Gain comes out first (72(e)(2)(B)), so the order is taxable, then tax-free cost. No required annual amount in the statute | 72(s)(1)(B); 72(e) |
| Payout over life or life expectancy | An individual designated by the holder (72(s)(4)) | Payments must begin within 1 year after death | If annuitized, an exclusion ratio of cost to expected return applies (Pub. 575 and Pub. 939 describe the ratio); if taken as systematic withdrawals, gain-first applies | 72(s)(2); 72(b); 72(e); Pub. 575 |
| Spousal continuation | Surviving spouse | None: the spouse is treated as the holder | No tax at the death. Tax arises when the spouse takes money out, on the gain first. On our reading, the spouse’s own death raises the 5-year question again for the next beneficiary | 72(s)(3) |
Source: 26 U.S.C. 72(b), (e), (s); 1411; IRS Publications 575 and 939. “Our reading” marks the points where the Code does not give a worked rule.
Three details that decide real cases:
- Starting the life-expectancy payout late costs you the option. The 1-year start in 72(s)(2)(C) is in the statute; the same sentence lets the Secretary set a later date “by regulations,” and we found none.
- An estate or trust cannot use the life-expectancy exit. The exception requires a “designated beneficiary,” defined as an individual. A contract left to the estate is on the 5-year clock, and 2026 trust and estate income above $16,000 is in the 37% bracket (Rev. Proc. 2025-32, Table 5), so leaving it in a trust that keeps the income is expensive.
- Death after payments started is a different rule. If the owner was already annuitizing, 72(s)(1)(A) lets the heir keep receiving payments at least as fast as before. Pub. 575 adds that guaranteed payments to a beneficiary under a life annuity are not income until the payments plus the annuitant’s tax-free amounts equal the cost, and only then fully taxable.
Worked example: $500,000 contract, $200,000 cost
The numbers below are our arithmetic from the 2026 single-filer brackets in Rev. Proc. 2025-32 (24% to $201,775 of taxable income, 32% to $256,225, 35% to $640,600), the 2026 standard deduction of $16,100, and the net investment income tax of 3.8% above $200,000. We assume the owner’s cost is $200,000, the contract is worth $500,000 at death, the heir is an adult child, unmarried, with $120,000 of other taxable income (AGI $136,100), no growth after death, and brackets unchanged.
| Path (gain $300,000) | Taxable each year | Federal tax | Share of the gain | What drives it |
|---|---|---|---|---|
| Lump sum in year 1 | $300,000 | $94,371 income tax plus $8,972 NIIT = $103,343 | 34.4% | Taxable income reaches $420,000: part is taxed at 32% and 35%; AGI of $436,100 is $236,100 over the NIIT threshold |
| 5-year window, gain first, $60,000 a year | $60,000 in each of years 1 to 5 | $14,400 a year = $72,000 | 24.0% | Stays in the 24% bracket; AGI of $196,100 stays under $200,000 so no NIIT. The $200,000 cost is withdrawn last and tax-free |
| 30 years, systematic withdrawals ($16,667 a year) | $16,667 for 18 years, then $0 | $4,000 a year for 18 years = $72,000 | 24.0% | Gain-first order; the same flat 24% on the same $300,000, much later |
| 30 years, annuitized (fixed 30-year period) | $10,000 a year | $2,400 a year for 30 years = $72,000 | 24.0% | Exclusion ratio 40% ($200,000 cost over $500,000 expected return); a period of 10 years or more is partial annuitization under 72(a)(2) |
Source: Rev. Proc. 2025-32 Tables 3; 26 U.S.C. 72(e), 72(b), 1411; our arithmetic. The 30-year period is an assumption, not the heir’s life expectancy from any IRS table.
What the table shows. The total tax is the same flat 24% on the same gain in the three slower paths; what moves is when the tax is paid and whether any year crosses a bracket or the NIIT line. The 5-year path works because of the gain-first order in 72(e)(2)(B): the heir can take the whole $300,000 gain in five equal slices and still leave $200,000 of tax-free cost to withdraw at the very end of the window. With growth, the extra gain is taxed too and the final withdrawal is no longer all cost. The lump sum in year 1 is the right answer only if the heir needs the cash or expects higher rates later.
The estate tax deduction (section 691(c)) and what changed in 2025
An heir who pays income tax on annuity gain that was also in an estate that paid federal estate tax gets a deduction. Section 691(c)(1)(A) allows “a deduction” in the same year the income is included, in the ratio of the IRD item to all IRD in the estate; Publication 559 says individuals claim it as an itemized deduction on Schedule A (Form 1040), line 16, and Publication 575 calls the deferred-annuity death benefit above cost an item of IRD. It is a deduction, not a credit, and no estate tax means no deduction.
Our arithmetic. If the estate’s marginal federal rate on the $300,000 of gain was the top rate of 40% (26 U.S.C. 2001(c), on amounts over $1,000,000), the estate tax attributable to it is $120,000, and that is the deduction in the year the heir includes the gain. Spread across five years that is $24,000 a year, against a 2026 unmarried standard deduction of $16,100, so it only helps if the heir itemizes.
Two 2025-law points sit on top of that:
| Provision of Public Law 119-21 | What it does | Effect on an inherited annuity |
|---|---|---|
| Section 70106 (estate and gift tax) | Sets the basic exclusion amount at $15,000,000 for estates of decedents dying and gifts made after December 31, 2025 | Few annuity heirs will have a 691(c) deduction: it requires federal estate tax, which starts above that amount for a 2026 death. Our page on the [estate tax exemption](/articles/estate-tax-exemption-2026) has the table |
| Section 70111 (itemized deductions) | Rewrites section 68: itemized deductions are reduced by 2/37 of the lesser of the deductions or taxable income above the start of the 37% bracket, for taxable years after December 31, 2025 | Section 68 lists no exception for the 691(c) deduction, so on our reading an heir in the 37% bracket loses 2/37 of it. Section 67(b)(7) keeps 691(c) out of miscellaneous itemized deductions |
| Sections 72, 691, 1014, 401(a)(9) | Not amended by the Act (Cornell’s amendment notes show nothing after 2022; our search of the enrolled text found “section 72” only in the new Trump account provisions) | The 5-year rule, no step-up, IRD and the IRA 10-year rule are the same in 2026 as in 2024 |
| Section 70102 (standard deduction) | Makes the higher standard deduction permanent: $15,750 single and $31,500 joint for 2025; $16,100 and $32,200 for 2026 (Rev. Proc. 2025-32) | Most heirs take the standard deduction, so a small 691(c) amount adds nothing |
Source: Public Law 119-21 (govinfo.gov) sections 70102, 70106, 70111; 26 U.S.C. 68, 67(b)(7), 2010(c)(3), 2001(c); Rev. Proc. 2025-32.
Qualified annuities: an annuity inside an IRA or 401(k)
If the annuity sits inside an IRA, 403(b) or 401(k), section 72(s) does not apply (72(s)(5)) and the beneficiary follows the retirement-plan rules in 401(a)(9) instead. That is where the SECURE Act of 2019 matters.
| Question | Nonqualified annuity | Annuity inside an IRA or plan |
|---|---|---|
| Controlling rule | 26 U.S.C. 72(s) | 26 U.S.C. 401(a)(9), applied to IRAs through 408(a)(6) and (b)(3) |
| Standard payout window | 5 years from the date of death (death before payments) | 10 years for a designated beneficiary who is not an eligible designated beneficiary, by December 31 of the 10th year (401(a)(9)(H)(i)(I); Pub. 590-B) |
| Longer payouts | Life or life expectancy, individual, start within 1 year; spouse becomes the holder | Eligible designated beneficiaries (spouse, minor child, disabled, chronically ill, or not more than 10 years younger than the owner) can use life expectancy (401(a)(9)(E)(ii), (H)(ii)) |
| What is taxed | Gain only, gain first (72(e)) | Pub. 590-B: if only deductible contributions were made, annuity payments are “fully taxable”; after-tax IRA money is recovered under the rules in Pub. 590-B |
| Step-up | None (1014(b)(9)(A)) | None: pre-tax retirement money is income in respect of a decedent too |
| Penalty | No 10% additional tax at death (72(q)(2)(B)) | Missing a required distribution carries the excise tax described in Pub. 590-B |
Source: 26 U.S.C. 72(s)(5), 401(a)(9)(E), (H); IRS Publication 590-B (2025). For the annual-distribution rules and tables see our inherited IRA page.
The practical difference: a nonqualified heir can wait almost five years and then withdraw, while an IRA-annuity heir under the 10-year rule may have annual withdrawals to take if the owner had passed the required beginning date. And a surviving spouse has more choices in the IRA, where Publication 590-B lets the spouse treat the IRA as their own, than in a nonqualified contract, where the spouse simply steps into the owner’s place.
Reading the Form 1099-R
| Box | What the 2026 instructions say | What to check |
|---|---|---|
| Box 7a, code 4 | “Use code 4 regardless of the age of the participant to indicate payment to a decedent’s beneficiary, including an estate or trust” | Code 4 is the death code; it can be paired with D, among other letters |
| Box 7a, code D | Annuity payments from nonqualified annuities, for a distribution from any plan or arrangement not described in section 401(a), 403(a), 403(b), 408, 408A or 457(b) | Check that it is on the form for a nonqualified contract |
| Payee name and TIN | For a distribution to a beneficiary, trust or estate, prepare the form “using the name and TIN of the beneficiary, trust, or estate, not that of the decedent” | A form in the decedent’s name or number is wrong; ask the carrier for a corrected one |
| Box 5 | For nonqualified commercial annuities, the premiums “recovered tax free during the year” based on the method used | This is the owner’s cost coming back; boxes 1, 2a and 5 should add up to your gain and cost |
| Box 2a | The taxable amount; leave blank only if the payer cannot reasonably obtain the data to compute it | If blank, compute it yourself from the owner’s cost in the contract records |
Source: Instructions for Forms 1099-R and 5498 (2026), Boxes 2a, 5 and 7a. Our page on 1099-R box 7 codes covers the other codes. The final return of the owner is a separate filing, see Form 1310 and the final return.
Mistakes that cost money
- Taking a check and re-buying elsewhere. Rev. Rul. 2007-24: the endorsed check “does not qualify as a tax-free exchange under § 1035(a)(3). Instead, the amount received is taxable to the extent set forth in § 72(e).” A direct exchange or assignment between the insurers is the only route; see our 1035 exchange page and the guaranty association limits if the insurer’s strength is a worry.
- Assuming the step-up applies. It does not, by the express words of 1014(b)(9)(A). The inheritance rule for houses and shares is the opposite: see our pages on step-up in basis and the tax on inheritance by asset.
- Letting the 5-year window run to the last month. The statute counts 5 years after the death, and a final-year lump sum on top of earlier withdrawals can push taxable income into the 32% to 35% brackets, as the table above shows.
- Missing the 1-year start for the life-expectancy payout. After that the 5-year rule is the fallback in the statute.
- Naming the estate or a trust. The life-expectancy exit requires an individual designated by the holder.
Before you choose
- Get three documents. The contract’s death-benefit section, the carrier’s statement of the owner’s cost (investment in the contract) and value at death, and the claim packet with its election deadlines.
- Find the death date, then the 1-year and 5-year dates. Both run from the date of death. Put them on a calendar.
- Model your own bracket. Use the table in this page with your other income. The question for most heirs is how much gain fits under the 24% bracket (to $201,775 for an unmarried filer in 2026) and under the NIIT line each year.
- Ask the carrier what it offers. Not every insurer offers every payout; the Code sets the limits, the contract sets the menu.
What a reader can do with this
- Write down the date of death, the contract value, the owner’s cost and who is named beneficiary. Those four facts decide which row of the options table applies.
- If you are the surviving spouse, compare keeping the contract (72(s)(3)) with taking cash; keeping defers tax and keeps the choice.
- If you are a non-spouse individual, compare the life-expectancy payout (election within 1 year) with the 5-year window using your own bracket and the worked example.
- If the money is in an IRA or 401(k) annuity, use the 10-year rule table and our inherited IRA page instead.
- If the estate paid federal estate tax, ask the executor for the estate tax attributable to the annuity so that the 691(c) deduction can be computed.
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Sources, read and saved on October 23, 2026: 26 U.S.C. 72, 67, 68, 401, 691, 1014, 1411, 2001 and 2010 (Cornell Legal Information Institute); Public Law 119-21 (govinfo.gov); IRS Publications 575, 559, 590-B and 939 (2025 editions); Instructions for Forms 1099-R and 5498 (2026); Rev. Proc. 2025-32; Rev. Rul. 2007-24 (IRB 2007-21); eCFR search of Title 26. The tax figures in the worked example, the 691(c) example and the payout comparison are our arithmetic from those documents; the contract values, the heir’s income and the 30-year period are assumptions. This is analysis of public documents, not investment, legal or tax advice.
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