If you inherit an individual retirement account, you generally don't have any immediate tax consequences. However, if you don't follow Internal Revenue Service rules regarding the handling of a so-called "decedent IRA," you could face taxes with a side dish of penalties. Spouses have the most flexibility in terms of inheriting an IRA, but even non-spousal beneficiaries can take simple steps to maximize tax savings.
If you're the spouse of the deceased account holder, you can roll over the decedent's IRA into your own without any tax consequences at all. You can also leave the IRA where it is and simply rename it in your own name. Once the account is transferred, you can treat it as your own in every way. For example, you could make contributions to the IRA, or you could roll it over to another tax-advantaged account, such as another IRA.
As a non-spousal beneficiary, your options with an inherited IRA are much more limited. You can't treat it as your own, and you must also retitle the account in a specific way, keeping the deceased owner's name for the benefit of you as beneficiary. However, you won't have to pay tax on the transfer of ownership.
Taxes are due on a decedent IRA the minute you take a distribution. Coupled with the fact that an IRA is a tax-advantaged account, it's generally a wiser move to keep the money in the account for as long as possible. As a spousal owner, you can refrain from taking distributions until you turn age 70 1/2. As a non-spousal owner, you'll have to start taking distributions immediately, and may have to withdraw the full amount of the IRA within five years. However, you may also be able to take distributions according to either your life expectancy or that of the original owner.
The IRS wants to encourage you to keep retirement account money where it is until you actually stop working. So, if you take money out of an IRA before you reach age 59 1/2, the IRS will add a 10 percent penalty for a "premature distribution." However, this penalty is waived if the distribution is made for something the IRS requires, as is the case of the IRA going to a non-spousal beneficiary.