You generally don't pay any income taxes on an inherited individual retirement account until you take distributions. However, moving the funds in the wrong way could cost you. Whether you want to consolidate the inherited IRA with your own, or simply move the money to what you think is a better investment, the rules differ depending on whether you are the decedent's surviving spouse.
If you're the surviving spouse of the decedent and the only beneficiary of the inherited IRA, you have the option to treat the inherited IRA as if it's your own rather than as one you inherited. If you make that election, you're free to roll over the inherited IRA, combine it with your other retirement accounts, or even convert it to a Roth IRA. However, once you make that election, you can't avoid the early withdrawal penalty because you're a beneficiary anymore. If you're not the sole beneficiary, but are the surviving spouse, you can't treat the account as if it's your own, but you can roll over any non-required distributions from the IRA to your own IRA.
If you didn't inherit the IRA from your spouse as the sole beneficiary, tax laws prohibit you from rolling over the money -- even to another beneficiary IRA. If you attempt to rollover an inherited IRA, the IRS treats it as two separate actions: First, a permanent distribution from the inherited IRA, which is taxable to the same extent any other distribution would be. Second, putting the money in the second IRA counts as your annual contribution, which means if you're putting in more than your annual limit, you'll face excess contributions penalties.
Just because you can't roll over your inherited IRA doesn't mean you can't change investments. The IRS does permit you to move the funds to a beneficiary IRA through a trustee-to-trustee transfer. With a trustee-to-trustee transfer, the money is never paid out to you like it is in a rollover. Instead, you tell the first bank where you want the money moved and it gets moved automatically.
When you do a trustee-to-trustee transfer, you must transfer the inherited IRA into a specially titled beneficiary IRA. The beneficiary IRA should be titled in the name of the decedent for the benefit of the beneficiary. For example it should read, "Jamie Hopkins, deceased, for the benefit of Jason Hopkins, beneficiary." You are not permitted to co-mingle the inherited IRA with your own IRAs -- or even combine it with other inherited IRAs. If the decedent died before taking distributions from your inherited IRA, once you have it in a properly titled account, it's possible that you can use the single life expectancy payout option, which allows you to stretch the distributions over your lifetime.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."