Inheriting an Annuity in California: Your Options and the Tax

Short answer: You have a few payout choices — a lump sum, spreading it over five years, or annuitizing — and a surviving spouse can usually just continue the contract (IRC § 72(s)). But here’s the part that surprises people: an inherited annuity does not get a step-up in basis. The gain above the owner’s cost is taxed to you as ordinary income. California has no inheritance tax, but the federal income tax hit can be real, so loop in a CPA.

Figures verified against IRC § 72(s) and the SECURE Act 10-year rule, 2026. This is general information, not legal advice for your situation.

The key contrast: no step-up on an annuity

If you’ve read our page on inherited houses, you know a home’s basis steps up to date-of-death value, which usually erases the capital gain. An annuity works the opposite way. There’s no step-up. Whatever the annuity grew above what the original owner paid in — the “gain” — stays taxable, and it passes to you when you inherit the contract.

An example. Your father, a Ventura retiree, bought a non-qualified annuity years ago for $100,000. By the time he passes, it’s worth $250,000. You inherit it. That $150,000 of growth is taxable — and it’s taxed as ordinary income (your regular tax-bracket rate), not at the lower capital-gains rate a house or stock would get. How and when you take the money determines how hard that hits.

Your payout options (non-qualified annuities)

For a non-qualified annuity (bought with after-tax dollars, not inside an IRA or 401(k)), the post-death rules live in IRC § 72(s). Your choices generally are:

• Lump sum. Take it all at once. Simple, but the entire $150,000 of gain lands in a single tax year — often pushing you into a higher bracket.
• Five-year rule. Empty the contract within five years of the owner’s death. You can spread withdrawals to soften the tax in any one year.
• Annuitization (“life expectancy” payout). Take payments stretched over your life expectancy, generally starting within a year of death. This spreads the taxable gain over many years — usually the most tax-efficient route.
• Spousal continuation. If you’re the surviving spouse, you can typically step into the contract and keep it going as if it were your own, deferring the tax until you take money out.

Because the gain is ordinary income, timing is everything. A lump sum in one year can cost far more tax than the same money stretched over a life expectancy. This is squarely a numbers question for your tax preparer.

Qualified (IRA/401(k)) annuities follow a different rule

If the annuity is held inside a retirement account — an IRA annuity or a 401(k) annuity — it’s a “qualified” annuity, and the SECURE Act’s rules apply instead. Most non-spouse beneficiaries must empty the inherited account within 10 years of the owner’s death (the “10-year rule”), and those withdrawals are taxable income. We cover that in detail on our inherited IRA 10-year rule page. The label on the account — qualified versus non-qualified — decides which rulebook you’re under, so that’s the first thing to nail down.

California, and why this is a CPA conversation

Good news on the state side: California has no inheritance tax and no state estate tax. Nobody sends you a California “death tax” bill for inheriting an annuity. But the federal ordinary-income tax on the gain is real, and it interacts with your other income, your bracket, and your other inherited assets. Whether a lump sum, the five-year rule, or a lifetime stretch costs you the least depends on your specific tax picture — and that’s genuinely your CPA’s job, not ours. We’ll happily refer you to a good one for free. Where we help is making sure the annuity, the beneficiary designations, and the rest of your plan actually fit together, because a beneficiary designation overrides your will and controls who gets the annuity in the first place.

Do I get a step-up in basis on an inherited annuity?

No. Unlike a house or stock, an annuity does not receive a step-up in basis at death. The gain above the original owner’s cost basis remains taxable and passes to you as the beneficiary.

How is an inherited annuity taxed in California?

The gain (value above the owner’s cost basis) is taxed as ordinary federal income, at your regular tax-bracket rate — not the lower capital-gains rate. California has no separate inheritance tax, but you still owe income tax on the taxable portion.

What are my payout options for an inherited non-qualified annuity?

Generally a lump sum, the five-year rule (empty it within five years), or annuitization over your life expectancy (IRC § 72(s)). A surviving spouse can usually continue the contract as their own and keep deferring the tax.

Is an inherited IRA annuity taxed the same way?

No. A qualified annuity held inside an IRA or 401(k) follows the SECURE Act rules, where most non-spouse beneficiaries must withdraw everything within 10 years. Non-qualified annuities follow the IRC § 72(s) post-death rules instead.

Can I spread out the tax on an inherited annuity?

Often yes. Choosing the five-year rule or annuitizing over your life expectancy spreads the taxable gain across multiple years instead of taking it all at once, which usually lowers the total tax. The right choice depends on your tax situation, so confirm it with a CPA.

The bottom line

An inherited annuity is one of the few inherited assets that gets no step-up, so the built-in gain is coming with it — taxed as ordinary income when you take it. Your payout choice (lump sum, five years, or a lifetime stretch) controls how much tax and when, and for a qualified IRA annuity the 10-year rule applies instead. The exact tax math is your CPA’s call, and we’ll point you to a good one for free. Where we come in is coordinating the annuity with your beneficiary designations and the rest of your plan so the whole thing works together. Talk to Eric.

Sources: IRC § 72(s) (required post-death distribution rules for non-qualified annuities — lump sum, five-year rule, life-expectancy payout, spousal continuation); IRC § 1014 (step-up in basis applies to property acquired from a decedent — annuities are income in respect of a decedent and are excluded); SECURE Act (10-year rule for inherited qualified retirement accounts). California has no state inheritance tax or estate tax.