Last month, I wrote about the step-up in basis—a hidden gem in the tax code that allows beneficiaries to sidestep capital gains taxes on inherited non-retirement accounts. It’s a great example of how understanding the rules can help you preserve more of what you’ve built.

This month, I want to talk about another lesser-known opportunity: the special tax treatment of inherited non-qualified annuities. “Non-qualified” simply means the annuity is not held inside a retirement account like an IRA or 401(k).

A QUICK WORD ABOUT ANNUITIES

Annuities tend to get a bad rap, and honestly, I understand why.

Some are overly complex or poorly designed for the person using them. But not all annuities are created equal. Some can play a very specific and helpful role, especially when someone wants to save beyond traditional retirement account limits.

Unlike IRAs or 401(k)s, annuities don’t require earned income and don’t come with annual contribution caps. They’re often used after retirement accounts are already maxed out. Some also offer guarantees around growth or income, which you simply can’t get from stocks or bonds.

Like most financial planning tools, annuities work best when they’re chosen intentionally as part of a broader strategy.

HOW NON-QUALIFIED ANNUITIES ARE TAXED

Here’s an important distinction between inherited non-qualified annuities and other inherited non-retirement accounts: non-qualified annuities do not receive a step-up in basis when inherited.

Instead, they follow what’s known as a last in, first out (LIFO) tax structure. That means the gains come out before the principal, and those gains are taxed as ordinary income—not capital gains.

Here’s what that looks like in practice:

If someone invests $200,000 into a non-qualified annuity and it grows to $500,000, the $300,000 of growth represents taxable income. If a beneficiary inherits that annuity and takes it as a lump sum, that $300,000 gets added to their income for that year.

Depending on their tax bracket, that could be a significant hit.

But this is where the planning opportunity comes in.

THE STRETCH: A LITTLE-KNOWN ADVANTAGE

What many beneficiaries don’t realize is that they don’t have to take an inherited non-qualified annuity all at once.

Spouses have an option called spousal continuation, which allows them to assume ownership of the annuity contract and treat it as their own, allowing the assets to continue growing tax-deferred.

Beneficiaries, including spouses, also have the option to stretch distributions over their lifetime. The insurance company calculates the required distributions based on the beneficiary’s life expectancy, resulting in smaller, incremental withdrawals instead of one large taxable event.

There’s also a five-year option, where the full amount is distributed over five years. But for many people, the lifetime stretch offers far more flexibility and tax efficiency.

If this sounds familiar, that’s because it resembles the old stretch IRA rules. The key difference? While the IRA stretch was eliminated with the Secure Act of 2019 (inherited IRAs must now be distributed within 10 years), the lifetime stretch for inherited non-qualified annuities is still available.

WHY THE STRETCH CAN BE SO POWERFUL

Most people inherit assets during their highest earning years—often while still working full-time—and adding a large amount of taxable income during that stage of life usually isn’t ideal.

By stretching the annuity, the annual tax burden stays lower. And if the beneficiary doesn’t actually need the money right away, it can continue growing inside the annuity.

I often explain it this way: instead of receiving one big check and a big tax bill, it’s almost like your loved one giving you money every month, which can be a beautiful thing. In some cases, those distributions can even extend to the next generation, particularly if the annuity’s growth outpaces the withdrawal rate.

Another benefit is control. Beneficiaries don’t have to take distributions monthly. Some prefer to take them annually and earmark them for travel, gifting, or other meaningful goals, so the money serves as a nice “bonus” to your regular budget.

HOW THIS FITS INTO YOUR OVERALL PLAN

Inherited annuities don’t come with the same tax advantages as inherited brokerage accounts, but that doesn’t make them a bad asset. It just means they require thoughtful planning.

If you want help maximizing retirement contributions, minimizing taxes, or figuring out how an inherited asset fits into your broader financial picture, I’m happy to help you evaluate your options and design a strategy that works for you.