You have several options when you inherit an IRA, and the one you choose can have a big impact on how much you pay in taxes.
Let's review some of the basic rules for an IRA account:
A Traditional IRA usually has only before-tax funds; there can be after-tax ( nondeductible ) contributions as well. This means that you need to consider carefully when you take withdrawals from a traditional IRA as the amount will be taxable income to you in that tax year. There can be a 10% penalty if you take a distribution prior to age 59½. Also, with a traditional IRA, once you reach the age of 70½, you must take Required Minimum Distributions (RMDs) based on your life expectancy.
A Roth IRA contains after-tax contributions and earnings from those contributions. If the account was established at least five years ago, the earnings are also considered non-taxable. The owner of a Roth IRA is never required to withdraw the funds.
If you inherit an IRA from your spouse, you can elect to treat the IRA as if it were your own. This resets the clock and the rules are now based on your age. Factors to consider before making this choice depend on when and how you want to take distributions. For a Traditional IRA, if your spouse was 70½ or older and had already started taking RMDs, then you can continue to take annual withdrawals based on your spouse's life expectancy schedule or take withdrawals based on your own life expectancy. For a Roth IRA no distributions are required. However, if you elect to treat the account as your own, any of the earnings portion taken before age 59 1/2 could be subject to the 10 percent, early withdrawal penalty.
There are two options available when you inherit an IRA from someone other than your spouse. You can choose to take distributions over your life expectancy, known as the stretch option. Or you must liquidate the account within five years of the original owner's death. Depending on the amount of the IRA, the stretch option can provide a great tax advantage, allowing you to take small taxable distributions each year.
To take advantage of the "stretch" option, you must take minimum distributions from the account based on your own life expectancy, starting by December 31 of the year after the original owner's death. These required withdrawals are similar to the required minimum distributions (RMDs) for IRA holders over age 70½, but they use a different life expectancy table. The withdrawals from a Traditional IRA will still be taxable, but the rest of the money can continue to grow tax-deferred in the account. If you do not take these distributions, you will be required to withdraw all of the money within the five years.
Don't rush to make any decisions, but do be aware that the clock is ticking.