If you inherit an IRA from a spouse, parent, or any other person, the inheritance itself isn’t taxable to you for federal income tax purposes. However, the funds in the IRA become taxable to you when you take distributions from the account. Here is what you need to know about taking distributions.

In general, a person who inherits an IRA must take required minimum distributions (RMDs) over his/her life expectancy or draw down the account in full by the end of five years following the year of the IRA owner’s death (“five-year rule”). Life expectancy is determined by looking at an IRS table for this purpose (see Table I in Appendix C of IRS Publication 590 (See www.irs.gov/pub/irs-pdf/p590.pdf).

Spousal Beneficiary

If an IRA is inherited by a surviving spouse, he/she can choose to roll over the funds to his/her own IRA. This allows the surviving spouse to postpone distributions until age 70 1/2 as well as to name new account beneficiaries. This rollover option can be used for part of the IRA; the rollover need not be all or nothing. A partial rollover allows the surviving spouse under age 59 1/2 to access the funds in the non-rolled-over account without an early distribution penalty.

Roth IRAs

While distributions from Roth IRAs are not taxable and are exempt from RMDs during the owner’s life, beneficiaries cannot keep the account open indefinitely to accrue tax-free income. Beneficiaries must take RMDs from Roth IRAs over their life expectancy. The same rules apply to distributions from all qualified tax deferred retirement plans.

2012 Inheritances

By September 30 of the year following the IRA owner’s death, determine who is the account beneficiary. It is this life that is used to figure required minimum distributions (RMDs) unless beneficiaries take a full distribution upon inheritance or rely on a five-year rule (explained later). If there are two or more individuals on the account, the life of the oldest beneficiary is used for RMD calculations. The older the beneficiary, the more rapidly the account must be drawn down. If there is someone who is not an individual, such as an estate or charity, named on the account, then no individual’s life can be used; the funds become distributable under the five-year rule. The account can be divided among beneficiaries by September 30 to maximize distributions for younger beneficiaries. If there is a non-individual beneficiary on the account after this date, then the five-year rule applies.

Future Inheritances

The same rules for 2012 apply to 2013 inheritances unless Congress changes the rules. There is a proposal being considered by the IRS to accelerate distributions to beneficiaries, requiring payouts be made within five years. Surviving spouses, children under age 18, and anyone disabled would be exempt. I will write an article to explain any regulations that may be issued.

Conclusion

Anyone who has inherited an IRA should consult with a tax advisor to make sure that RMDs are being taken as required. The failure to take RMDs results in a 50% penalty unless reasonable cause for the failure can be shown.