Dad Bought a $150,000 Annuity That Grew to $300,000 and Left It to You. The $150,000 Gain Is Ordinary Income to You, and the Step-Up That Erased the Tax on His House Never Touches It

Dad dies in 2026 and leaves his 60-year-old daughter two things. One is the house he bought for $120,000, now worth $420,000. The other is a deferred annuity he funded with $150,000 of after-tax savings, which has grown to $300,000.

She sells the house and owes essentially nothing on $300,000 of appreciation due to section 1014. She cashes in the annuity and gets a Form 1099-R showing $150,000 of taxable income, taxed like a paycheck. It’s the same father and the same estate, with opposite results. One short clause in the tax code explains both.

Section 1014 Erases the House Gain and Stops at the Annuity

The step-up in basis lives in Section 1014 of the Internal Revenue Code. It resets an heir’s basis to the property’s fair market value at the date of the decedent’s death. Her basis in the house becomes $420,000, so selling at that price produces zero gain.

Then comes Section 1014(c). It says the step-up “shall not apply to property which constitutes a right to receive an item of income in respect of a decedent under section 691.” Income in respect of a decedent (IRD) is income Dad earned but never paid tax on, and decades of deferred growth inside an annuity fit that description. Section 691(a) directs that income to the person who, by reason of the death of the decedent, acquires the right to receive the amount.

So the annuity keeps Dad’s numbers. His $150,000 of contributions comes back to her tax-free as his “investment in the contract.” The other $150,000 counts as annuity income and income in respect of a decedent under the gross income rules, so it’s taxed at ordinary rates that top out at 37%.

A Lump Sum Turns $150,000 of Gain Into a $40,876 Federal Bill

The assumptions are as follows. She files single in 2026 and earns $106,100 in wages. After the $16,100 standard deduction, her taxable income is $90,000, and her federal tax comes to $14,512.

Add the $150,000 gain and her taxable income jumps to $240,000. The extra dollars fill the 22% and 24% brackets, and everything above $201,775 is taxed at 32%. The dollars above each line pay the higher tax rate, and there are a lot of them.

A second tax also kicks in. Annuity income counts as net investment income(NIIT), and her modified AGI of $256,100 passes the $200,000 single threshold. That triggers the 3.8% net investment income tax on the excess.

Spreading the Gain Over Five Years Saves About $6,446

If Dad died before he started taking annuity payments, the law requires the whole contract to be paid out within 5 years after the death of such holder. Inside that window, she controls the timing. Withdrawals made before payments start are taxed to the extent allocable to income on the contract, so the gain comes out first.

Suppose the contract stops growing. She withdraws $30,000 a year for four years, all of it gain. In year five she takes the remaining $180,000: $30,000 of gain plus her tax-free $150,000 of basis. Each year her taxable income tops out at $120,000 and the 3.8% surtax never applies.

That plan costs $6,886 a year, or $34,430 over five years, which is $6,445.80 less than the lump sum. Heirs already on Medicare get a bonus: smaller income spikes keep the income that sets Medicare premiums two years later from rising.

A longer stretch is also available. Section 72(s)(2) allows payouts over a period not extending beyond the life expectancy of such beneficiary, provided they begin not later than 1 year after the date of the holder’s death. Annuitized payments are taxed under the General Rule, which applies to commercial annuities, so part of each check is a tax-free return of Dad’s basis.

Three Moves Before You Sign the Insurer’s Claim Form

1. Turn down the default lump sum until you’ve seen every option in writing. The life-expectancy stretch goes away if payments haven’t started within one year of the death.
2. Ignore your age. The 10% early-withdrawal penalty does not apply to distributions made on or after the death of the holder, so a 50-year-old heir can spread payouts without a penalty.
3. Claim the IRD deduction if the estate paid estate tax. Section 691(c) gives heirs a deduction for the federal estate tax attributable to the annuity. With a 2026 basic exclusion of $15,000,000, only large estates qualify.

State income tax applies on top of all this, and rates vary from zero to double digits depending on where the heir lives. The IRD trap on an inherited annuity is one of several quiet rules that drain retirement accounts (we listed nine of them in a free tax trap guide if you want the rest). Parents can plan ahead too: spending the annuity during retirement and leaving appreciated stock or real estate behind hands heirs assets that do get the step-up.

The right payout depends on your bracket in each of the next five years, so run the numbers with a CPA before the insurer’s check gets cut.

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