Annuities in a Trust: Tax Rules and Trustee Duties After the Settlor's Death

When an annuity is part of a trust estate, successor trustees face a set of tax rules that differ sharply from every other asset class. Unlike stocks and real estate — which receive a step-up in cost basis at death — annuity gains are Income in Respect of Decedent (IRD) under IRC § 691. All of that deferred income is still owed, and when the trust is the beneficiary, federal law requires full distribution within five years. Combine that deadline with trust-level tax brackets that reach 37% at $16,000 of income, and an annuity in a trust is among the highest-cost inherited assets a trustee can administer. This guide explains the rules, the options, and the steps to take.

Step 1: Identify what type of annuity you have

Before you can manage an inherited annuity, you need to know what kind it is. The rules vary substantially across types.

Qualified vs. non-qualified

• Qualified annuity: Purchased inside a tax-qualified account — an IRA, 401(k), 403(b), or similar plan. The annuity contract is the investment vehicle inside the retirement account. Rules are governed by the IRA or plan rules (SECURE 2.0, 10-year rule, RMD requirements), not by IRC § 72(s). See our IRAs and Trusts guide for this scenario.
• Non-qualified annuity: Purchased with after-tax dollars outside any retirement account. This is the subject of this guide. Rules are governed by IRC § 72. The owner's cost basis (premiums paid) is not taxed again; all earnings above that basis are ordinary income to the recipient.

Deferred vs. immediate (income) annuity

• Deferred annuity: Accumulates value over time. The most common type in trust estates. The owner deposited money, it grew tax-deferred, and the payout phase hadn't yet started at death. These are subject to the distribution rules below.
• Immediate (income) annuity: The owner exchanged a lump sum for a stream of payments that had already begun. What happens at death depends on the payout option the owner elected (life only, period certain, joint and survivor). Read the contract — there may be a remaining period-certain payment stream that the trust continues to receive, or the payments may have already ceased if a life-only payout was elected and the annuitant died.

Variable vs. fixed

• Variable annuity: Value fluctuates with underlying investment subaccounts. The account value at date of death is the fair market value for estate and trust inventory purposes. Many variable annuities include enhanced death benefit riders — guaranteed minimum death benefits (GMDB) that may exceed the account value — and those excess amounts are still ordinary income, not capital gain.
• Fixed or fixed-indexed annuity: Value grows at a stated or indexed rate. Use the accumulation value (contract value) at date of death for estate and inventory purposes.

The critical fact: annuities do not receive a step-up in basis

IRC § 1014 provides a stepped-up cost basis for inherited assets at death — the basis is reset to the fair market value on the date of death, eliminating built-in capital gains.¹ This applies to stocks, real estate, partnership interests, and most investment assets.

Annuities are excluded. Annuities are Income in Respect of Decedent (IRD) under IRC § 691.² The deferred income that accumulated inside the annuity during the owner's lifetime was never taxed. At death, that income doesn't disappear — it's still owed. The beneficiary (or trust) who receives the annuity proceeds must recognize the gain as ordinary income when they receive distributions, exactly as the original owner would have.

What this means in practice: If your parent paid $100,000 in premiums and the annuity grew to $300,000 at death, the $200,000 gain is fully taxable as ordinary income when the trust takes distributions. There is no capital gains rate, no exclusion, and no basis step-up.

The five-year rule when the trust is the beneficiary (IRC § 72(s))

When the owner of a deferred non-qualified annuity dies, IRC § 72(s) determines how the beneficiary must take distributions.³ The rules differ depending on whether the beneficiary is a natural person or a non-natural person:

A trust is a non-natural person. There is no mechanism to stretch annuity distributions over a beneficiary's life expectancy when a trust is named — the 5-year rule applies regardless of the ages of the trust's underlying beneficiaries or the terms of the trust document. This is different from the inherited IRA rules, which allow see-through trust treatment under certain conditions. For non-qualified annuities under IRC § 72(s), no comparable see-through rule exists.

The five-year deadline: The entire account value must be distributed by December 31 of the fifth calendar year following the owner's death. Example: owner dies March 15, 2026 → the trust must receive the last distribution by December 31, 2031.

When the trust was the annuity owner during the settlor's lifetime (IRC § 72(u))

In the less common scenario where a trust (rather than the settlor as an individual) was the owner of the annuity during the settlor's lifetime, IRC § 72(u) creates an additional problem.⁴

Under § 72(u), a deferred annuity held by a non-natural person is not treated as an annuity contract for tax purposes — meaning the annual increase in value is currently taxable to the owner each year, rather than tax-deferred. The benefit of tax deferral is lost while the contract is owned by a non-natural person.

The grantor trust exception: During the settlor's lifetime, most revocable living trusts are grantor trusts — the settlor is treated as the owner for income tax purposes. In this case, § 72(u) does not apply while the trust is a grantor trust, because the grantor (a natural person) is the "true" owner. Tax deferral is preserved. At the settlor's death, the trust becomes a non-grantor trust, and § 72(s) then governs the required distributions.

If the trust was irrevocable during the settlor's lifetime and was the annuity owner, § 72(u) would have applied annually. Confirm with the CPA what income, if any, was already recognized by the trust prior to the settlor's death. Any income reported under § 72(u) increases the trust's cost basis in the contract and reduces the remaining gain subject to tax on distribution.

The tax cost: compressed trust brackets

Even if the trust distributes annuity proceeds within five years, those proceeds are ordinary income — taxed at the trust's income tax rates. In 2026, trust ordinary income brackets compress quickly:⁵

An individual filer doesn't reach 37% until roughly $626,000 of taxable income. The trust reaches 37% at $16,000. If the trust retains annuity distributions rather than passing income to beneficiaries, the after-tax cost can be severe.

Example: Trust is the beneficiary of a $300,000 annuity with $100,000 cost basis ($200,000 of taxable gain). If the trust distributes all $200,000 of gain in a single year with no offsetting distributions to beneficiaries, approximately $184,000 of the gain sits in the 37% bracket (plus 3.8% NIIT on net investment income). Federal tax: roughly $75,000–$80,000. If the same $200,000 were spread across two adult-child beneficiaries in the 22% bracket, the tax would be roughly $44,000 — a $30,000+ difference.

The DNI rule: annuity gains may not carry out to beneficiaries automatically

One complexity specific to annuity gains: under the trust tax rules, the deduction for distributions to beneficiaries is limited to distributable net income (DNI).⁶ Capital gains allocable to corpus typically are not included in DNI and are taxed at the trust level regardless of distributions. Annuity distributions, however, are ordinary income — they are generally includible in DNI and can carry out to beneficiaries via Schedule K-1 if the trustee has distribution discretion and makes qualifying distributions.

This means that if the trust document gives the trustee discretion to distribute income to beneficiaries, distributing the annuity proceeds to individual beneficiaries shifts the tax bill from the compressed trust brackets to the beneficiaries' personal rates — which are almost always lower. Work with the CPA to confirm the DNI analysis before deciding how to structure distributions from the annuity proceeds.

The gain-first (LIFO) rule for partial withdrawals

Under IRC § 72(e), amounts received from a non-qualified deferred annuity before the annuity starting date are treated as income first — gains come out before return of premium (LIFO, last-in-first-out).³

If the trust takes partial distributions over the five-year period, each dollar distributed is considered gain until all accumulated gain is exhausted. Only then is the cost basis (premiums) returned tax-free. This is the opposite of the FIFO treatment used for stock sales.

What this means: If the trust plans to spread annuity distributions over five years, the early distributions are fully taxable as ordinary income. There is no planning opportunity to front-load the return of basis — the IRS gets the tax first, every time.

Surrender charges at death

Most non-qualified deferred annuity contracts include surrender charges during the accumulation phase — typically a declining schedule over 7–10 years (e.g., 7%, 6%, 5%... down to 0%). These charges are assessed when the contract is surrendered before the charge period expires.

Death waiver: The vast majority of annuity contracts include a death benefit provision that waives surrender charges upon the owner's death. The insurance company pays the death benefit (the contract value or the guaranteed minimum death benefit, whichever applies) without deducting a surrender charge. Verify this with the insurance company — read the contract or call the insurer's estate services department.

Rarely, older annuity contracts do not include a death waiver. If charges apply, they reduce the distribution proceeds but do not change the ordinary income character of the gain.

Date-of-death value: estate and trust inventory

For estate inventory and Form 706 purposes (if an estate tax return is required), the date-of-death value of a non-qualified deferred annuity is:⁷

• Variable annuity: The account value (subaccount value) at the close of business on the date of death. If the contract has an enhanced death benefit (guaranteed minimum death benefit above the account value), the full death benefit amount is the estate tax value — even though the excess over account value has no income tax cost basis.
• Fixed or fixed-indexed annuity: The accumulation value (policy value) at date of death, which typically equals the death benefit for most fixed contracts.

Request a date-of-death statement from the insurance company in writing. This statement is needed for the trust's asset inventory, for any estate tax return, and for the trust's CPA to establish the taxable gain (death benefit minus cost basis).

The IRC § 691(c) IRD deduction

If the decedent's estate was large enough to owe federal estate tax (above the $15 million OBBBA-permanent exemption in 2026), the estate paid estate tax on the full value of the annuity — including the deferred gain that has not yet been taxed for income tax purposes.² This is a case of economic double taxation: the same dollars are subject to both estate tax and income tax.

To mitigate this, IRC § 691(c) provides an income tax deduction for the portion of estate tax attributable to IRD items. When the trust receives taxable annuity distributions, the CPA can calculate the § 691(c) deduction — the trust deducts from income the amount of estate tax that was allocable to the annuity. This deduction appears on Schedule B, line 3 of Form 1041 (or as a miscellaneous deduction not subject to the 2% floor under IRC § 67(e)).

The § 691(c) deduction is often overlooked. If the estate paid estate tax, confirm with the estate attorney and CPA that the IRD deduction is being calculated and claimed on Form 1041 as annuity distributions are taken.

In-kind distribution of the annuity contract to beneficiaries

One option that successor trustees sometimes consider: instead of surrendering the annuity and distributing cash, distribute the annuity contract itself in-kind to the individual beneficiaries. If the beneficiaries are named natural persons, they could then elect life-expectancy payouts under § 72(s) — stretching distributions over their lifetimes and avoiding the trust's compressed brackets.

However, this strategy has significant complications:

• Gain recognition on transfer: Under IRC § 72(e)(4)(C), a transfer (assignment) of an annuity contract generally triggers recognition of the gain as ordinary income at the time of transfer. This means distributing the contract in-kind to beneficiaries may itself be a taxable event — the trust recognizes the full gain at the time of the assignment, not spread over future distributions.
• Insurance company restrictions: Many insurers will not permit assignment of a contract to multiple beneficiaries or will not permit changes to the designated beneficiary after the owner's death. The insurer's rules govern what is contractually possible.
• Whether in-kind distribution passes gain to beneficiaries: Some private letter rulings have addressed trust distributions of annuity contracts to individual beneficiaries without triggering gain at the trust level, but PLRs apply only to their recipients and the analysis is fact-specific.

Before attempting an in-kind distribution of an annuity contract, consult with the trust's estate attorney and CPA. The tax consequences depend on how the contract is assigned, what the trust document permits, and the insurance company's rules. In most cases, surrendering the annuity and distributing cash — while paying the tax — is the cleaner path.

Practical steps for successor trustees

1. Locate the contract. Look for annuity statements in the settlor's papers. Check with the annuity company directly — insurers are required to process death claims and will have the contract on file. The state's unclaimed property database is a resource if the company is unknown.
2. Contact the insurance company immediately. Request the claims department or estate services team. You will need: death certificate, your letters of trusteeship or Certificate of Trust, and your trust's EIN. Ask for the date-of-death value in writing, the death benefit amount, any surrender charge waiver confirmation, and the required distribution rules for the contract.
3. Identify the cost basis. The insurer can provide the original premium amount and any prior basis-reducing withdrawals. This is the cost basis for calculating the taxable gain. Confirm with the CPA.
4. Understand the 5-year deadline. Calculate the latest permissible distribution date: December 31 of the fifth full calendar year after the owner's date of death. Mark it clearly in the trust administration records.
5. Coordinate with the CPA. Annuity distributions are reported on Form 1099-R, which the insurer issues to the trust. The CPA will report the taxable portion on Form 1041. If there is a § 691(c) estate tax deduction available, the CPA needs the estate tax return (Form 706) to calculate it.
6. Model distribution timing. Work with the CPA and advisor to decide whether to take all proceeds in one year or spread them over the five-year period, and how much to distribute to beneficiaries vs. retain in the trust. Distributing proceeds to beneficiaries in lower tax brackets is typically the most tax-efficient strategy — but only if the trust document permits discretionary distributions and the beneficiaries consent.

Asset comparison: annuity vs. IRA vs. stock in trust