Functionally graded materials (FGMs) provide a unique solution to combine distinct properties within a single component to enhance its overall performance. Understanding the microstructure and residual stress distribution is particularly important as the material dissimilarity in FGMs can result in high residual stress that affects the mechanical integrity of structural components. This work aims to study the microstructure and residual stress of additively manufactured FGMs and the effects of isothermal annealing. In this study, 316L stainless steel/Inconel 625 FGMs were built by direct energy deposition and characterized by optical and electron microscopy as well as synchrotron-based X-ray diffraction. Our study reveals that thermal annealing at 500°C for 3 h has minimal effects on the microstructure and chemistry of the graded materials, but effectively relieves the residual stress and leads to a uniform distribution of residual stress.