A lot of red tape is involved when you inherit an IRA, whether your benefactor is your spouse, a parent or another relative or friend. If you don't follow the rules for an inherited IRA to the letter, you can wind up with a giant tax bill at the end of the year. When you an inherit an IRA, it pays to talk to a financial adviser before you do anything with the funds.
Rules for Spouses
When you inherit an IRA from a spouse, you have a few options. You can decide to treat the IRA as your own, meaning you can contribute to it and leave the money in there. You'll need put your name on the IRA as the account owner. You can also roll the amount in the inherited IRA into your own pre-existing IRA or, in some cases, into another retirement plan, such as ar 401(k). As the beneficiary of an IRA, you may also start taking distributions from it.
Rules for Others
If you inherit an IRA from anyone who isn't your spouse, you don't get to treat the IRA as if it were your own. You can move the money in the IRA from one account to another, but you need to be extra careful about the way the move is handled. Unless you want to pay a hefty tax and a penalty, you must open an IRA in the name of your benefactor but for your benefit.
You have two options when it comes to taking distributions from an IRA you've inherited. You can choose to clear out the account, either right away or by the end of the fifth year after you inherited the IRA. Your other option is to take distributions from the IRA spread out over the course of your life expectancy, as determined by the IRS based on your age. Taking distributions from a traditional over the remainder of your lifetime cuts down on the taxes you'll owe. If you inherit a Roth IRA, you don't owe tax on the distributions unless the account is less than 5 years old when you start taking out earnings.
The IRS has slightly different rules for IRAs inherited by an estate instead of a person. If the owner of a traditional IRA dies before the age of the 70 1/2 and her estate is named as the beneficiary, the entire amount of the IRA must be distributed by the end of five years. If she is 70 1/2 or older when she dies, the amount in the IRA can be distributed to her estate based on her life expectancy when she died.