Inheriting an annuity can be a financial opportunity — but only if you understand the rules.

One of the most important regulations to be aware of is the five-year rule. This IRS guideline tells non-spouse beneficiaries how long they have to withdraw funds from certain annuities after the original owner dies.

Annuity beneficiaries need to understand their options and act quickly. The five-year rule gives you time, but not unlimited freedom.

If you’ve recently inherited an annuity, here’s what you need to know about the five-year rule and how to plan accordingly to avoid a messy tax situation.

The 5-year rule for inheriting an annuity

When someone dies and leaves behind a nonqualified annuity (one purchased outside a qualified retirement account), the five-year rule, an IRS regulation, typically applies.

Here’s how it works: A non-spouse beneficiary has five years from the date of the annuity owner’s death to withdraw all money from the account.

“This can offer additional tax-management opportunities by stretching withdrawals over multiple tax years,” says Stephen Kates, CFP, financial analyst for Bankrate.

If any funds remain in the annuity after five years, the IRS may impose penalties and fees, undoing much of the financial benefit of inheriting the annuity in the first place.

There are no required minimum distributions (RMDs) during the five-year period, so you can choose to withdraw the money in a single lump sum or take out smaller chunks over time. Technically, you could leave the contract untouched for four years and 11 months, then empty the account right before the five-year deadline.

But keep in mind that a portion of withdrawals from an inherited annuity are taxed as ordinary income. If a large sum is taken in a single year — especially in the fifth year — it could push the beneficiary into a higher tax bracket.

This rule primarily applies to nonqualified annuities — those not tied to retirement plans like IRAs. Qualified annuities (those inside an IRA or 401(k)) are subject to their own set of rules, which often include RMDs starting at a certain age.

Other annuity distribution rules

You might not be stuck with following the five-year rule. Here are other common options when inheriting an annuity:

It’s also worth noting that if a beneficiary is an estate, trust or charity, the five-year rule is the only distribution option.

Some annuities come with enhanced death benefits, but these optional riders don’t override IRS distribution rules.

”Death benefit riders will offer a boost or added protection,” says Kates. “But ultimately, the beneficiary will inherit the value assigned by the contract rules. The options for distributions remain the same.”

3 things beneficiaries need to know about the 5-year rule

Understanding the five-year rule is about more than simply following IRS rules — it’s also essential for effective estate planning. Whether you own an annuity or expect to inherit one, planning ahead can help avoid confusion and minimize taxes.

Don’t delay

Options such as the nonqualified stretch must be elected within specific time frames — often within 60 days of filing a claim for the death benefit. If those windows are missed, more restrictive rules like the five-year deadline automatically go into effect.

If you’re a beneficiary, it’s also worth noting you won’t be on the hook for the 10 percent IRS penalty usually applied to withdrawals from annuities prior to age 59 ½. And those pesky surrender charges — the fees insurance companies charge if you withdraw more than 10 percent of your annuity value? Those don’t count against beneficiaries, either. 

“Surrender charges or early withdrawal penalties will not apply to the beneficiary even if the withdrawals take place within the period that would have been the original surrender period for the owner,” says Kates. 

Watch the tax implications

Withdrawals from nonqualified annuities are taxed as ordinary income on the gain portion. Depending on the size of the account and your other income, this could significantly increase your tax bill. Stretching distributions over time can help you manage the tax burden more effectively.

Only the earnings in a nonqualified annuity are taxable. The original contributions are returned to you tax-free, but calculating the taxable portion can be tricky. Consulting a financial advisor or tax professional is often a smart move.

The 5-year rule doesn’t always apply

The five-year rule generally applies to non-spouse beneficiaries who do not elect another option (such as the nonqualified stretch) in time. Spouses have more flexibility — they can become the new owner of the contract, roll it into their own annuity or elect a payout option mentioned above (such as the five-year rule). 

Since spousal rules differ from non-spouse rules, it’s best to consult a tax professional or financial advisor to fully understand your options.

Annuities within retirement accounts, like IRAs, are governed by yet another set of rules, including the 10-year distribution rule under the SECURE Act, which may or may not include annual RMDs depending on whether the original owner had already started taking them.

Bottom line

If you inherit a nonqualified annuity and fail to act, the IRS may impose the five-year rule. You will be required to withdraw the entire balance within five years of the original owner’s death. Understand the rules, act early and talk to a financial advisor if you’re not sure what to do.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.