Annuities in Estate Planning: Probate, Taxes, and Beneficiaries

Annuities in estate planning offer one big advantage and one big catch. The advantage: money in an annuity passes directly to whoever you name as beneficiary, skipping probate entirely. The catch: heirs owe ordinary income tax on the gains, there is no step-up in basis the way there is with stocks or real estate, and federal law forces distributions out of the contract on a fixed timeline that depends on the type of annuity and who inherits it. Federal estate tax rarely enters the picture — the 2026 exemption is $15 million per person — but the income tax bill is real and worth planning for.¹

Why Annuities Skip Probate

A beneficiary designation on an annuity contract is a direct agreement between you and the insurance company. When you die, the insurer pays the person you named without waiting for a court to validate your will. The proceeds never become part of your probate estate, which spares your family the delays, legal fees, and public exposure that come with probate.

This only works if there is a valid, living beneficiary on file. Leave the field blank, or name someone who has already died, and the death benefit typically reverts to your estate and gets pulled into probate anyway. Because the beneficiary form overrides your will, an outdated designation can send money to an ex-spouse or a deceased relative regardless of what your other estate documents say. Keeping designations current is the single most important thing you can do to make an annuity function the way you intend.

What Heirs Will Owe in Tax

Inherited annuity gains are taxed as ordinary income, not at the lower capital gains rates that apply to most inherited investments. Federal ordinary income rates run from 10% to 37% in 2026. Whether the entire distribution is taxable, or only the growth, depends on how the annuity was funded.

Qualified Annuities

A qualified annuity sits inside a retirement plan such as a 401(k) or traditional IRA, and it was funded with pre-tax dollars. Because the government never collected income tax on the contributions, the entire distribution is taxable when the beneficiary receives it.² A $300,000 inherited qualified annuity produces $300,000 of taxable income spread across whatever years the beneficiary takes it.

Non-Qualified Annuities

A non-qualified annuity was purchased with after-tax money outside a retirement plan, so only the growth is taxable. Federal law uses an “exclusion ratio” to split each payment into a tax-free return of the original investment and a taxable earnings portion.² If a contract is worth $200,000 at death but the owner invested $150,000, the taxable gain is $50,000; the $150,000 of original cost comes back tax-free.

No Step-Up in Basis

This is where annuities behave very differently from other inherited assets. When you inherit a house or a brokerage account, the cost basis usually resets to fair market value at the date of death, wiping out decades of unrealized gains. Annuities do not get this treatment. Under 26 U.S.C. § 1014(c), property that constitutes income in respect of a decedent is excluded from the step-up rules.³ Annuity gains fall into that category under 26 U.S.C. § 691, so the beneficiary inherits the owner’s original basis and owes ordinary income tax on every dollar of accumulated growth.⁴

From a pure tax-efficiency standpoint, an annuity is one of the less favorable assets to leave to heirs compared with appreciated stock or real estate. That does not make it a bad estate planning tool. The probate bypass, guaranteed income features, and creditor protections often outweigh the tax cost. But beneficiaries need to plan for the income tax hit rather than assume the gains vanish at death.

How Fast Heirs Have to Take the Money

Federal law sets hard deadlines for emptying an inherited annuity. The rules differ for non-qualified and qualified contracts, and missing a deadline can strip the contract of its favorable tax treatment.

Non-Qualified Annuities

The rules for non-qualified annuities come from 26 U.S.C. § 72(s). If the owner dies after annuity payments have already started, the beneficiary must continue receiving distributions at least as fast as the method already in use. If the owner dies before payments begin, the default is that the entire balance must be distributed within five years of death.²

There is an important exception. A named individual beneficiary can elect to stretch distributions over their own life expectancy if payments begin within one year of the owner’s death. The annual required amount is calculated from IRS life expectancy tables, and the beneficiary can always take more than the minimum. This life expectancy option can dramatically reduce the annual tax bill by spreading the taxable gain across decades. Not every carrier offers it, so confirm with the insurance company before assuming it is available.

Trusts, estates, and charities cannot use the life expectancy stretch. When any of those is the beneficiary, the five-year rule applies.

Qualified Annuities

Qualified annuities held inside retirement plans follow the distribution rules in 26 U.S.C. § 401(a)(9). For most non-spouse beneficiaries, the SECURE Act replaced the old life expectancy stretch with a ten-year rule: the entire account must be emptied by the end of the tenth year after the owner’s death.⁵ Whether annual withdrawals are also required within that window depends on whether the original owner had reached their required beginning date for minimum distributions. If yes, the beneficiary must take annual amounts in years one through nine. If no, the account simply has to be emptied by year ten.

A narrow group of “eligible designated beneficiaries” can still stretch over their own life expectancy: the surviving spouse, minor children of the owner (until they reach the age of majority), disabled individuals, chronically ill individuals, and beneficiaries who are not more than ten years younger than the owner.

Surviving Spouses Have the Most Options

Surviving spouses get the best treatment of any beneficiary, which is why spousal planning drives so much of the strategy around annuities. For non-qualified annuities, 26 U.S.C. § 72(s)(3) lets the surviving spouse become the new holder of the contract and continue it as if they had always owned it.² No forced distributions, no five-year clock, and the tax deferral continues uninterrupted. For qualified annuities, the surviving spouse can usually roll the inherited annuity into their own IRA and reset the distribution timeline entirely.

Federal Estate Tax on Annuities

Even though income tax dominates the annuity conversation, the value of an annuity payable to a beneficiary is also included in the owner’s gross estate for federal estate tax purposes. Under 26 U.S.C. § 2039, the includible amount is proportional to how much of the purchase price the decedent contributed.⁶ Employer contributions to a qualified plan annuity count as the decedent’s own for this purpose, so employer-funded 401(k) annuities are fully includible.

In 2026 the federal estate tax exemption is $15 million per individual, a level set by the One Big Beautiful Bill Act signed in July 2025.¹ Married couples can effectively shield up to $30 million through portability. Most families will not owe federal estate tax on an annuity. When the threshold is crossed, the same annuity funds can face both estate tax and income tax; federal law provides a partial offsetting income tax deduction, but the relief is incomplete.

Naming a Trust as Beneficiary

Directing an annuity to a trust gives the owner control over how and when heirs receive the money. That is useful for minor children, beneficiaries with spending problems, or blended families. The tradeoff is a layer of tax complexity that can backfire if the trust is drafted poorly.

Under 26 U.S.C. § 72(u), an annuity held by a non-natural person loses its tax-deferred status, and the accumulated gain becomes ordinary income immediately.⁷ The statute carves out exceptions: it does not apply when a trust holds the annuity as an agent for a natural person, when an estate acquires the annuity because of the owner’s death, when the annuity is held under a qualified retirement plan, or when it is an immediate annuity.

Most estate planning trusts try to fit through the “agent for a natural person” door. To qualify, the trust generally has to show that every beneficiary is a living human, with no corporations, charities, or other entities in the chain. Fail that test and the full deferred gain can become taxable at once, which is exactly the outcome the trust was meant to prevent. The specific language matters, and it goes beyond what a generic revocable trust template contains. This is an area where paying for professional drafting is usually worth it.

Keeping Your Designations in Order

Because the beneficiary form controls, an annuity plan is only as good as the paperwork on file with the insurer. For each person you name, the carrier needs full legal name matching government identification, Social Security number, date of birth, and current address. Designate both primary beneficiaries, who inherit first, and contingent beneficiaries, who inherit if all primaries have already died. Allocations across all beneficiaries must total exactly 100%; forms that do not add up get rejected.

Most carriers use a standardized change of beneficiary form available through their administrative office or online portal. Processing typically takes one to two weeks, after which the insurer sends a written confirmation. Keep that confirmation with your other legal documents. Your family will need it to file a claim.

Spousal Consent for Workplace Plan Annuities

If your annuity sits inside a qualified retirement plan such as a 401(k) or pension, federal law adds a step. These plans default to paying the death benefit as a qualified joint and survivor annuity for your spouse.⁸ To name anyone other than your spouse, you need a written spousal waiver that identifies the specific alternate beneficiary, and the spouse’s signature has to be witnessed by a notary or plan representative. Without that waiver, the designation is invalid and your spouse takes the benefit regardless of what the form says.

This requirement does not reach non-qualified annuities purchased outside an employer plan, and it does not apply to IRAs. But for anything tied to a workplace plan, skipping the spousal consent step is one of the quietest ways an estate plan can fail.

1
Internal Revenue Service. What’s New — Estate and Gift Tax
2
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
3
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
4
Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents
5
Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
6
Office of the Law Revision Counsel. 26 USC 2039 – Annuities
7
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
8
Internal Revenue Service. Retirement Topics – Qualified Joint and Survivor Annuity