The Rule That Surprises Every Family: No Step-Up in Basis
When you inherit most appreciated assets — a home, a brokerage account, shares of stock — the tax code resets their cost basis to fair market value on the date of death. Decades of capital gains simply vanish for income tax purposes. Families plan around this rule, often without realizing it, because it's what makes inheriting appreciated property so tax-efficient.
Annuities are the great exception. An annuity's deferred gain does not disappear at death. It carries over to the beneficiary as income in respect of a decedent (IRD) — and when the beneficiary receives it, it is taxed as ordinary income at the beneficiary's own rates. Not capital gains rates. Ordinary income, stacked on top of whatever the beneficiary already earns.
A parent dies owning two assets, each worth $300,000, each purchased years ago for $100,000.
The stock: the child inherits with a stepped-up basis of $300,000, sells the next week, and owes essentially no income tax.
The annuity: the child inherits $200,000 of deferred gain intact. As payments or withdrawals come out, that $200,000 is taxed as ordinary income. For a child in a combined federal and NJ bracket of 35%, that's roughly $70,000 in income tax — on the same-sized inheritance that would have passed tax-free as stock.
This single difference is why annuities deserve specific attention in an estate plan. The contract that felt conservative and safe during the owner's life can be, from the beneficiary's chair, the most heavily taxed asset in the estate.
New Jersey Inheritance Tax: It Depends Entirely on Who Inherits
New Jersey no longer has an estate tax, but it still has an inheritance tax — one of only a handful of states that does — and annuity proceeds are subject to it. What matters is the beneficiary's relationship to the deceased:
- Class A — exempt. Spouses, civil union partners, children, grandchildren, parents, and stepchildren pay no NJ inheritance tax on inherited annuities.
- Class C — 11–16%. Siblings and sons- or daughters-in-law pay inheritance tax above a $25,000 exemption.
- Class D — 15–16%. Nieces, nephews, cousins, friends, and everyone else pay tax from nearly the first dollar.
Now stack the taxes. A nephew inheriting a $300,000 annuity with $200,000 of gain faces NJ inheritance tax on the proceeds and federal and state income tax on the gain as it comes out. The combined bite can approach half the contract's value — an outcome the owner almost certainly never intended, and one that beneficiary-designation planning can often dramatically improve if it's done during the owner's life.
Your Payout Options — and the Deadlines That Control Them
What an annuity beneficiary can do depends on who they are and what kind of annuity it is. The options differ sharply, and several are use-it-or-lose-it:
Surviving spouses: the continuation option
A surviving spouse named as sole beneficiary can typically elect spousal continuation — stepping into the owner's shoes and continuing the contract with its tax deferral intact. No immediate tax, no forced payout. This is usually, though not always, the most flexible choice, and it's available only to spouses.
Non-spouse beneficiaries of non-qualified annuities
Beneficiaries generally choose among: a lump sum (all deferred gain taxed as ordinary income in a single year — frequently the worst option, and often the default if no election is made); the five-year rule (funds must be fully distributed within five years of death, with flexibility about timing inside that window); or life-expectancy payments, sometimes called the non-qualified stretch — spreading distributions and the tax over the beneficiary's lifetime. The stretch typically must be elected and begun within one year of the owner's death. Miss the window, and the most tax-efficient option is gone permanently.
Qualified annuities (inside IRAs and retirement plans)
An annuity held inside an IRA follows retirement account rules, not annuity rules: under the SECURE Act framework, most non-spouse beneficiaries must empty the account within 10 years, with only limited classes of "eligible designated beneficiaries" (including spouses, disabled beneficiaries, and certain others) able to stretch longer. The 10-year clock plus ordinary income treatment makes distribution timing a genuine tax planning exercise, not an afterthought.
Many carriers mail beneficiary paperwork that defaults to a lump sum, and grieving families sign it just to complete the process. Once the lump sum is paid, the tax outcome is locked. If you've recently inherited an annuity, the single most valuable thing you can do is make no election until you understand all of them. The deadlines allow enough time to get advice — but not unlimited time.
Common Mistakes We See
- Taking the lump sum by default — converting a spreadable tax bill into a single-year spike, often pushing the beneficiary into higher brackets.
- Missing the one-year stretch window on non-qualified contracts because nobody told the family it existed.
- Beneficiary designations that contradict the estate plan — an ex-spouse still named, a deceased primary with no contingent, or "estate" as beneficiary, which forces probate and generally forces the least favorable payout schedule.
- Ignoring the inheritance tax return. Where Class C or D beneficiaries inherit, NJ requires an inheritance tax return and payment on a deadline — and NJ inheritance tax generally must be addressed before certain assets fully release.
- No coordination between siblings when multiple beneficiaries each hold elections with different tax consequences for each of them.
If You're the Owner, Not the Beneficiary: Plan Now
Everything above is what your family inherits if the contract is left on autopilot. During the owner's life, options exist that don't exist after death: reviewing and correcting beneficiary designations so they work with the estate plan rather than against it; evaluating whether deferred gains should be recognized strategically during low-income years rather than dumped on beneficiaries; considering a 1035 exchange into a contract whose structure serves the actual goal; and, where long-term care is the real risk, understanding how the annuity would be treated by NJ Medicaid. An annuity review during life is the difference between your beneficiaries choosing among good options and choosing among bad ones.
Frequently Asked Questions
Just the gains, for income tax purposes. The original owner's investment in the contract (the basis) comes out income-tax-free; the deferred earnings are taxed as ordinary income as they're distributed. NJ inheritance tax, where it applies, is a separate tax calculated on the value passing to you — the two taxes operate independently.
Generally no. Each beneficiary typically makes an independent election on their share — one can stretch while the other takes a lump sum. That independence is useful, because the right answer depends on each beneficiary's own tax bracket, age, and needs.
The contract passes through probate as an estate asset, and the payout options narrow considerably — the stretch is generally unavailable, and distribution is typically compressed into roughly five years. It's one of the most tax-expensive ways for an annuity to pass, and it's almost always the result of an oversight rather than a plan. If you're an owner reading this: check your designation this week.
No — death-benefit distributions to beneficiaries are exempt from the 10% penalty regardless of the beneficiary's age. The ordinary income tax still applies, but the penalty does not.