Your options for handling an inherited individual retirement arrangement primarily depend on your relationship to the person from whom you inherited the IRA. Internal Revenue Service rules provide spouses of a deceased IRA owner with different options than non-spouses. These rules are somewhat complex and must be carefully followed or you can incur higher tax liabilities and potential tax penalties on the inherited IRA.
Inherited IRA From Spouse
IRS rules give you three options for handling an inherited IRA from your spouse, one of which is to treat the IRA as your own. Using this option, you designate yourself as the account owner. A second option is to treat the IRA as your own by rolling it over into your own IRA account. With either of these two options, you can make contributions to the IRA. The third option is to treat yourself as the IRA beneficiary rather than the owner. You cannot make additional contributions to the IRA with this option.
Inherited IRA From Non-spouse
Inheriting an IRA from anyone other than your deceased spouse means you cannot treat the IRA as your own. No further contributions can be made to the account, nor can the IRA be rolled over into another IRA or retirement account. You are considered the IRA beneficiary and must receive distributions from the IRA according to IRS beneficiary rules.
Required Minimum Distribution
At some point, all inherited IRAs must be distributed to beneficiaries according to IRS required minimum distribution rules. For non-spouses inheriting an IRA directly from the deceased owner, the RMD options depend on whether the deceased IRA owner died before or after the date to start taking RMDs. If the owner died after, non-spouse beneficiaries have the option of using the owner's life expectancy under the IRS tables or their own life expectancy. If the owner died before taking RMD or a Roth IRA is involved, a non-spouse beneficiary can only take the RMD under the IRS life expectancy tables using his own life expectancy.
A non-spouse beneficiary must begin taking RMDs by December 31 in the year following the IRA owner's death. Failure to do so will result in the IRA being subject to the five-year rule -- that is, the beneficiary must take a full distribution of the IRA within five years of the original owner's death. This type of distribution usually has the worst tax consequences for the beneficiary and is often the result of a mistake by the beneficiary. In some instances, the beneficiary may be able to lessen the effects of the mistake, but additional tax penalties will apply.