Inheriting an IRA is no consolation for losing a loved one. What you don't need on top of that personal loss is paying a lot more to the federal government in taxes than necessary because you don't know the rules for handling an inherited IRA. If you don't take the required distributions in the specified time frame from an inherited IRA, you must pay a tax penalty equal to 50 percent of the amount you should have withdrawn.
Option for Spouses
If you inherited an IRA from your spouse, you have a special option to treat the IRA as if it were your own account. This means that you can roll the money into your existing IRA or simply re-title the inherited IRA in your own name rather than as a beneficiary. In addition, you do not have to take required minimum distributions from the account until you reach age 70 1/2. However, be aware that once you elect to treat the IRA as your own, you no longer qualify for the early withdrawal penalty exception for distributions made to beneficiaries.
If you inherit an IRA from a non-spouse or you elect not to treat the account as your own, one option is emptying the entire IRA by the end of the fifth year after the IRA owner's death. For example, if the owner died during 2010 and you elected the five-year option, you would have to empty the account by Dec. 31, 2015. However, you would not have to take out any money before that date unless you wanted to take a distribution.
Minimum Annual Distributions
If you would rather leave the money in the IRA for a longer period of time, elect to take minimum annual distributions. Though these are required each year, they are generally smaller and allow you to take advantage of the tax-sheltered growth of the IRA for longer. The amount you have to take out each year depends on whether the owner was taking required distributions before she died and your age. If the owner was taking required distributions, the size of the required distributions is based on your life expectancy or the IRA owner's life expectancy, which ever is longer, as determined by the Single Life Expectancy table in IRS Publication 590. If the owner died before she had to take required distributions, you use your life expectancy as figured by the Single Life Expectancy table in IRS Publication 590.
Moving an Inherited IRA
If you inherited the IRA from your spouse and you elect to treat it as your own, you can move the money around with rollovers and transfers without any additional restrictions. However, if you are a non-spouse beneficiary, the only way to move the money in the account is with a trustee-to-trustee transfer to another IRA clearly named as a beneficiary IRA, such as "Freddie Marth, decedent, for the benefit of James Marth, beneficiary." With a trustee-to-trustee transfer, the money moves directly from the decedent's IRA to the beneficiary IRA without you touching it. If you remove the money from the account, even if you think you're going to roll it over, you're stuck with the distribution because rollovers are not permitted.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."