Annuities and Estate Planning: The Step-Up Basis Trap

Annuities are one of the largest blind spots in estate planning. A stock portfolio worth $2M passes to your heirs with a full step-up in basis — they can sell immediately and pay zero capital gains tax. A variable annuity worth $2M with $700,000 of deferred gains passes with no step-up — every dollar your heirs withdraw above your original premiums is taxed as ordinary income at up to 37%, on top of any estate tax already paid on the same dollars. If your estate includes substantial non-qualified annuities, this is a planning problem worth solving before you die.

Why Annuities Don't Get a Step-Up in Basis

The step-up in basis rule (IRC §1014) is the default for most inherited property: the heir's basis becomes the fair market value at the decedent's date of death, permanently eliminating capital gains tax on all pre-death appreciation. It does not apply to income in respect of a decedent (IRD) — items that represent income the decedent earned but never collected, and that remain taxable even after death.

Annuity gains fall squarely into IRD. Under IRC §1014(c), property doesn't get a step-up when it represents an IRD item as defined in IRC §691. The rationale: the tax deferral of an annuity was always contingent on eventually paying tax on the gain — the owner just hadn't withdrawn it yet. Death doesn't forgive that deferred tax liability. It transfers it to your heirs.

This is categorically different from appreciated stock, real estate, or even a closely-held business interest — all of which step up to fair market value at death, wiping out decades of pre-death gain for income tax purposes. The step-up is arguably the most valuable tax benefit in the estate planning code, and annuities are one of the few common assets that don't qualify for it.

The Double-Tax Problem

When a non-qualified annuity is included in your taxable estate, it faces a potential two-layer tax hit:

1. Federal estate tax. The annuity's full fair market value — including the deferred gain — is included in your gross estate under IRC §2033 and §2039. At a 40% estate tax rate, this affects estates above the $15M federal exemption (permanently set by the One Big Beautiful Bill Act, effective 2026).²
2. Income tax on the IRD. When your heirs withdraw the deferred gains, they pay ordinary income tax at their marginal rate — up to 37% in 2026 on income above $640,600 (single filer) / $768,600 (married filing jointly).³ There is no capital gains rate for annuity income. Even if the annuity held equity sub-accounts for 30 years, the gain comes out as ordinary income under IRC §72(e).

Worked example: A $20M estate includes a non-qualified variable annuity with $1.5M fair market value: $800K in premiums paid and $700K of deferred gains.

Contrast with an identically appreciated stock portfolio: it would step up to FMV at death, eliminating the entire $259,000 income tax. The $700K of pre-death appreciation would escape income tax permanently.

What Happens to a Non-Qualified Annuity When You Die: IRC §72(s)

Under IRC §72(s), when a non-qualified annuity owner dies, the contract must be distributed under one of four options:⁴

Option 1: Lump sum

The beneficiary receives the entire contract value in a single payment. The excess of the amount received over the owner's investment in the contract (cost basis = premiums paid) is includable in the beneficiary's gross income in the year of receipt. For large annuities, this can be catastrophic: forcing $700K of ordinary income onto a single year's return may push a normally middle-bracket heir into the 37% bracket, or spike IRMAA Medicare surcharges for two subsequent years.

Option 2: 5-year rule

Distributions must be completed by December 31 of the 5th calendar year after the owner's death. The beneficiary controls the timing of withdrawals across those years to manage bracket exposure — but all gains are still taxable as ordinary income. Under IRC §72(e)'s LIFO rule, gains come out before return of premium. This option offers meaningful bracket planning flexibility compared to a forced lump sum.

Option 3: Life-expectancy annuitization

If distributions begin within 1 year of the owner's death and are structured as annuity payments over the beneficiary's life expectancy, the income tax is spread over many years. This maximizes bracket management. The option is contractual — not all policies offer it — and once selected, payments are irrevocable. The exclusion ratio (IRC §72(b)) means a portion of each payment is a tax-free return of the original investment, reducing the effective tax rate on each distribution.

Option 4: Spousal continuation (IRC §72(s)(3))

A surviving spouse who is the named sole beneficiary can elect to continue the contract as if he or she were the original owner. The deferral continues, no distribution is required, and the problem is deferred to the survivor's eventual death or withdrawal — at which point the strategies below apply. This is the only scenario where the inherited annuity's IRD problem can be meaningfully deferred. It applies only to a surviving spouse; no other beneficiary qualifies.

Five Strategies to Reduce the Estate Planning Cost of Annuities

1. 1035 Exchange to Life Insurance

A tax-free exchange under IRC §1035 allows you to convert a non-qualified annuity directly into a life insurance policy without triggering income tax on the deferred gain at the time of exchange. The original cost basis carries into the new contract.⁵

Life insurance death benefits are received by heirs income-tax-free under IRC §101(a). You permanently convert an IRD item (annuity gain, taxable as ordinary income) into a non-IRD item (life insurance death benefit, income-tax-free). If the policy is owned by an Irrevocable Life Insurance Trust (ILIT), the death benefit is also removed from your taxable estate, solving the estate tax problem simultaneously.

This strategy requires medical insurability — underwriting at the time of the 1035 exchange. It also requires analysis of surrender charges if the annuity is still within its surrender period. For a 68-year-old with a $1.5M annuity carrying $700K of gains, the math frequently favors the exchange: the heirs' after-tax inheritance can increase by six figures compared to inheriting the annuity directly.

2. 1035 Exchange to a Hybrid Long-Term Care Policy

A non-qualified annuity can be exchanged under IRC §1035 into a hybrid life/LTC policy or a long-term care annuity. LTC benefits paid from a qualifying IRC §7702B policy are received income-tax-free, and any residual death benefit from a life policy with an LTC rider is also received income-tax-free under IRC §101(g).⁵

This strategy solves two problems simultaneously: it converts the IRD liability into a tax-free LTC benefit, and it funds an LTC policy without new out-of-pocket premiums. A $300K annuity exchanged into a hybrid LTC policy might provide $600K–$900K in LTC benefits — while eliminating the income tax exposure if benefits are used for care, and leaving a smaller residual to heirs if not. For clients who both need LTC coverage and carry large annuities, this is frequently the best available path. See the LTC planning guide for a complete comparison of LTC structures.

3. Name a Charity or Donor-Advised Fund as Beneficiary

Tax-exempt organizations — charities, donor-advised fund sponsors — pay no income tax on IRD.⁶ If a $700K deferred annuity gain passes to a charity or donor-advised fund, zero income tax is triggered. The full fair market value generates an estate tax charitable deduction under IRC §2055.

This is the annuity equivalent of naming a charity as your IRA beneficiary. The optimal portfolio architecture for charitable families: leave step-up-eligible assets (appreciated stock, real estate) to heirs, and leave IRD assets (IRAs, annuities) to charity. Heirs get full value without income tax drag; charity gets full value without income tax drag. No one leaves value on the table. See the DAF estate planning guide for the mechanics of naming a DAF as a retirement account or annuity beneficiary.

4. Roth Conversion (for Annuities Inside Qualified Plans and IRAs)

If the annuity is held inside a traditional IRA, 401(k), or 403(b), the estate planning mechanics shift. The annuity still has an IRD problem — but the solution toolbox includes Roth conversion.

Converting an IRA-held annuity to a Roth IRA pays ordinary income tax now, but heirs inherit a Roth IRA with completely tax-free qualified distributions (including all future growth), no required minimum distributions during the original owner's lifetime, and no 10-year mandatory income tax drag under SECURE 2.0. For clients with large qualified annuities who want to reduce the IRD burden on their heirs, systematic Roth conversion is one of the most powerful tools available. The full decision framework is in the IRA estate planning guide.

5. Systematic Withdrawal and Reinvestment in Step-Up-Eligible Assets

In cases where the annuity has modest gains relative to the current account value, or where the owner is in a lower income tax bracket during retirement, the simplest strategy is systematic annual withdrawals (managing income tax impact across years) and reinvestment in assets that receive a step-up at death: diversified equity, real estate, or municipal bonds.

Each dollar of annuity gain converted from ordinary-income-rate treatment to a step-up-eligible equity position saves heirs up to 37% in future income tax. The math favors current withdrawal when: (a) the owner's current tax bracket is meaningfully lower than the heirs' projected bracket when they'll inherit; (b) the annuity has low surrender charges; and (c) the owner doesn't need the annuity's guaranteed benefits. Compare the after-tax positions carefully before surrendering any annuity with a guaranteed living benefit — those riders have real value that shouldn't be abandoned without analysis.

Annuities Inside Irrevocable Trusts: The IRC §72(u) Trap

Some advisors recommend placing non-qualified annuities inside irrevocable trusts for asset protection or estate planning. This triggers a significant — and often unrecognized — tax problem.

Under IRC §72(u), an annuity held by a non-natural person (a corporation, LLC, or irrevocable trust) is not treated as an annuity for income tax purposes. The tax-deferred accumulation that is the entire economic justification for holding an annuity disappears: the income buildup inside the contract is taxed currently to the owner at ordinary income rates, as if it were a plain investment account.⁴

Two exceptions preserve tax-deferred treatment: (1) annuities held by a natural person as agent (custodial accounts); and (2) annuities held in a grantor trust, where the grantor is treated as the owner for income tax purposes. A revocable living trust — which is a grantor trust while the grantor is alive — preserves tax-deferred treatment because the grantor is the deemed owner. An irrevocable non-grantor trust does not.

Bottom line: fund irrevocable trusts with assets that benefit from trust ownership — business interests, real estate, concentrated stock positions. Annuities belong in individual ownership or a revocable grantor trust, not irrevocable trust wrappers. If an annuity is already inside an irrevocable trust, a 1035 exchange to a life insurance policy may still be available to correct the situation while grantor trust status is maintained.

Qualified Annuities Inside IRAs and 401(k)s

If the annuity is held inside a qualified retirement account (IRA, 401(k), 403(b), 457(b)), it follows the account's distribution rules — not IRC §72(s). This means:

• SECURE 2.0 10-year rule: Non-spouse beneficiaries generally must distribute the entire account balance by December 31 of the 10th calendar year after the owner's death. Under T.D. 10001 (July 2024), when the decedent was past the required beginning date, heirs must also take annual RMDs during the 10-year period.
• Annuity payment schedule vs. 10-year rule: If the account holds an annuity that has already been annuitized, the annuity payment schedule may or may not align with the 10-year rule — this requires specific contract analysis and often coordination with the plan administrator.
• No IRC §72(u) issue: IRAs and qualified plans are exempt from the non-natural person rule, so annuities inside these accounts retain their deferred treatment regardless of who owns the account.

For a complete treatment of inherited IRA rules, the 10-year rule, and the see-through trust analysis, see the IRA estate planning guide.

Decision Framework: What to Do With a Large Non-Qualified Annuity

7 Annuity Estate Planning Mistakes

1. Assuming annuities get a step-up in basis like stocks. This misconception leads families to significantly overestimate the net inheritance heirs will receive. A $1.5M annuity with $700K of deferred gains leaves heirs a $259,000–$435,400 income tax bill, depending on the estate's size. Model the after-tax inheritance, not the gross contract value.
2. Naming the estate — or a testamentary trust — as beneficiary. When an annuity passes to the estate, the executor must distribute the gain within 5 years under IRC §72(s). When it passes to a non-grantor irrevocable trust, IRC §72(u) eliminates tax-deferred treatment and trust income is taxed at compressed brackets (the 37% rate applies at approximately $15,650 of trust income in 2026). Name a natural person, charity, grantor trust, or DAF as beneficiary.
3. Placing a non-qualified annuity inside an irrevocable trust. IRC §72(u) kills tax deferral immediately upon transfer. Advisors who recommend this approach often don't understand the income tax consequences. Annual taxable income from the inside buildup is triggered from the moment of transfer.
4. Ignoring the 1035 exchange option. Many annuity owners don't realize they can exchange their annuity for life insurance — tax-free. The gain doesn't disappear (it defers into the policy's basis) but the eventual death benefit passes income-tax-free to heirs, permanently eliminating the IRD problem. Insurability and surrender charges are the two practical constraints to evaluate.
5. Failing to update beneficiary designations after life changes. Annuity beneficiary designations supersede your will — exactly like IRAs. An ex-spouse named before a divorce remains the beneficiary unless the form is updated. Review all annuity designations alongside other account designations after marriage, divorce, death, or birth. See the beneficiary designations guide for a complete checklist.
6. Forcing a lump-sum distribution on heirs without bracket analysis. When a non-spouse beneficiary inherits a large annuity and takes a lump sum, all the deferred gain lands on their return in a single year. A $700K ordinary income spike can push a middle-bracket heir into the 37% bracket for that year, trigger IRMAA surcharges, reduce Roth conversion capacity, and increase AGI-based phaseouts. The 5-year rule or life-expectancy option frequently reduces the aggregate tax cost substantially — but beneficiaries must elect it early, often within months of the owner's death.
7. Treating qualified and non-qualified annuities the same. Non-qualified annuities follow IRC §72(s) with 5-year, life expectancy, spousal continuation, and lump sum options. Qualified annuities (inside IRAs or 401(k)s) follow the IRA/plan rules, including SECURE 2.0's 10-year mandatory distribution rule and T.D. 10001 annual RMD requirements when the decedent was past the required beginning date. Different rules, different strategies.