What Happens to an Annuity When Your Spouse Dies

Annuities are among the most confusing assets to inherit — and one of the most consequential decisions you'll face. The most important first step almost nobody knows about: the spousal continuation option. Not tax or legal advice; your contract documents and a specialist govern your specific situation.

First: qualified or non-qualified?

The most important distinction isn't the annuity type (variable, fixed, indexed) — it's how it was funded.

• Non-qualified annuity: funded with after-tax money outside of an IRA or employer plan. This is the most common type for retirees. The rest of this page focuses here.
• Qualified annuity: held inside an IRA, 401(k), 403(b), or similar employer plan. The annuity wrapper matters less than the account type — these follow the same rules as any inherited retirement account. See inherited IRA rules for surviving spouses and 401(k) options for surviving spouses.

How to tell which you have: Did the premium come from an IRA or through a workplace retirement plan? Qualified. Did it come from a bank or brokerage account, or with after-tax savings? Non-qualified.

The spousal continuation option — the single most important thing to know

Under IRC §72(s)(3), if you are the sole primary beneficiary, you have the right to step into the shoes of the original owner — to continue the annuity contract in your own name as though you were always the owner.¹

What spousal continuation means in practice:

• No immediate taxation. You don't owe income tax on the deferred gain at your spouse's death. The entire gain continues to compound tax-deferred until you take distributions.
• No surrender charges. Continuing the contract avoids surrender-charge penalties that would apply on a lump-sum distribution during a surrender period (typically 6–10 years for newer contracts).
• You inherit the cost basis. The original purchase price transfers to you. You'll owe ordinary income tax on the gain when you eventually distribute — but the timing is yours to control.
• Your distribution schedule. As the new owner, you choose when and how much to take, subject to the contract's annuity start date. No forced distribution unless you trigger one.

If you don't elect continuation: distribution options for non-qualified annuities

Lump-sum distribution

You receive the full account value. The entire gain — account value minus the cost basis — is taxable as ordinary income in the year received.² On a large annuity, this can be brutal: a $350,000 annuity with $150,000 of gain means $150,000 of ordinary income added to your other income in one year. For a single filer at typical widow income levels, that can hit the 22% or 24% bracket — and may trigger IRMAA Medicare surcharges if your MAGI exceeds $109,000.³ Surrender charges may apply on top of taxes.

Five-year liquidation

You can spread distributions over up to five years, ending by the fifth anniversary of your spouse's death.¹ This is more tax-efficient than a single lump sum — spreading taxable income across multiple years may keep you in lower brackets. You're not required to take equal amounts; you choose the pace as long as the full balance is distributed by the deadline.

Annuitization

Convert the contract into a stream of payments — for life, for a period certain (10 or 20 years), or a combination. Each payment is split between taxable gain and non-taxable return of basis using an "exclusion ratio." If your cost basis is $180,000 and you expect to receive $300,000 in total payments, 60% of each payment is a non-taxable return of basis and 40% is taxable income. Annuitization is often the most tax-efficient method if you expect to live long enough to recover the basis gradually.

The critical tax fact: no step-up in basis

Almost every asset you inherit from a spouse gets a "step-up" in cost basis to the date-of-death value — wiping out the tax on appreciation during your spouse's lifetime. Annuities are a major exception.

Annuity gains are classified as Income in Respect of a Decedent (IRD) under IRC §691.⁴ The step-up rule under IRC §1014 does not apply to IRD assets. You inherit the original cost basis — not the current value. Every dollar of gain that built up during your spouse's lifetime remains taxable to you as ordinary income when you take distributions.

The contrast with other assets makes the stakes clear:

• Investment portfolio worth $500,000 with a $200,000 cost basis: you inherit it with the basis stepped up to $500,000. Sell it the day you inherit it — zero tax on $300,000 of gain.
• Annuity worth $500,000 with a $200,000 cost basis: you inherit the original $200,000 basis. The $300,000 of gain is still fully taxable as ordinary income — every dollar of it, spread across however many years you take distributions.

This is why spousal continuation is so valuable: it doesn't eliminate the tax — but it lets you control the timing. You can take small distributions each year to stay in a lower bracket instead of receiving the entire gain at once.

Withdrawals from a non-qualified annuity: gains come out first

For a non-qualified annuity that hasn't been annuitized, withdrawals follow a last-in, first-out (LIFO) rule under IRC §72(e)(5).¹ Gains are deemed distributed before basis. Every dollar you withdraw is fully taxable ordinary income until you have depleted the entire gain; only after that do tax-free returns of basis begin.

Example: annuity account value $420,000, cost basis $170,000, deferred gain $250,000. Your first $250,000 in withdrawals — regardless of how many years it takes — is 100% taxable ordinary income. Only after $250,000 has been taken out does each subsequent dollar come out tax-free.

This LIFO rule applies to withdrawals. Annuitization uses the exclusion ratio instead, which is typically more favorable for long-term distributions.

Variable annuities: guaranteed minimum death benefits (GMDB)

If the annuity is a variable annuity, it may include a GMDB — a contractual guarantee that the beneficiary receives at least some floor amount, even if investment performance was poor. Common structures:

• Return of premium: you receive at least what your spouse paid in, even if the portfolio lost value.
• Annual step-up (ratchet): the death benefit locks in periodic portfolio highs, typically on each contract anniversary.
• Roll-up: the death benefit grows at a guaranteed rate (e.g., 5%/year) regardless of investment returns.

If the GMDB is higher than the current account value, you receive the death benefit amount — not just the account value. On spousal continuation, GMDB treatment varies by contract. Some insurers reset or eliminate the death benefit upon continuation; others preserve it. Check the prospectus or call the insurer before deciding.

How to find the cost basis

The insurer should have records of the original premium payments. Request a "cost basis statement" or "tax basis history" from the insurance company. If the annuity was purchased decades ago, you may also find premium payment history on old statements or Form 1099-R records. Keep this documentation — it determines how much of every future distribution is taxable.

Your immediate action list

1. Locate the contract and call the insurer. Get the spousal continuation deadline and confirm your beneficiary status.
2. Request cost basis documentation in writing — total premiums paid net of any prior tax-free distributions.
3. Don't take a lump sum under deadline pressure. Adding $100,000+ to your taxable income in one year may push you into a higher bracket, trigger IRMAA, and increase the taxable portion of your Social Security benefits simultaneously. Model the tax before committing.
4. Coordinate with your other accounts. The annuity decision doesn't happen in isolation. IRAs, pension income, Social Security, and annuity distributions all interact through IRMAA, the Social Security taxation threshold, and your marginal bracket.
5. Get professional guidance before the deadline. Annuity elections are typically irreversible. Unlike an IRA rollover (which has a 60-day reversal window), once you distribute or annuitize you generally cannot undo it.

Related guides

• Inherited IRA Rules for Surviving Spouses — if the annuity is inside an IRA, these rules apply
• What Happens to a 401(k) When Your Spouse Dies — employer-plan annuities follow 401(k) beneficiary rules
• The Widow's Tax Penalty — single-filer brackets and IRMAA directly affect annuity income taxation
• Roth Conversion Strategy for Widows — how to use the joint-year window before annuity distributions begin
• Managing Your Investments After Your Spouse Dies — broader financial transition framework

Sources

1. 26 U.S. Code § 72 — Annuities; certain proceeds of endowment and life insurance contracts (Cornell LII). §72(s)(1): annuity must begin post-death distributions; §72(s)(3): surviving spouse as sole beneficiary may be treated as the holder and continue the contract; §72(e)(5): LIFO treatment for withdrawals from non-annuitized contracts. Values verified as of 2026.
2. IRS Publication 575 (2025) — Pension and Annuity Income. Tax treatment of annuity distributions; exclusion ratio calculation; cost basis recovery; ordinary income characterization of gains.
3. Kiplinger — Medicare Premiums 2026: IRMAA Brackets and Surcharges. 2026 IRMAA Part B tier 1 threshold: $109,000 MAGI for single filers; base premium $202.90/month.
4. IRS Publication 559 (2025) — Survivors, Executors, and Administrators. Income in Respect of a Decedent (IRD) under IRC §691: annuity gains are IRD; IRC §1014 step-up in basis does not apply to IRD items, meaning inherited annuity gain retains the decedent's original basis.