Did you recently inherit a traditional IRA? The tax rules in this area can be perplexing, especially since you are likely to be emotional over the passing of a loved one. Take a deep breath and consider the options.

For simplicity, this discussion will be divided into two sections: one for spousal beneficiaries and the other for nonspouse beneficiaries. Spousal beneficiaries generally have more flexibility.

Spousal beneficiaries: Assuming you are the sole beneficiary of a traditional IRA, you may choose to treat your spouse's IRA as your own. This means you can contribute to the IRA, if you have compensation. Furthermore, if you are younger than 70½, you do not have to take required minimum distributions (RMDs). Note: RMDs are generally required after reaching age 70½, but this requirement for IRAs has been suspended for the 2009 tax year. 

Alternatively, you may leave the IRA in your spouse's name, with you as the beneficiary. If your deceased spouse died after age 70½, you generally must base subsequent RMDs on the longer of your single life expectancy or the deceased's life expectancy. Otherwise, distributions may be based on your single life expectancy, or the account must be emptied out in five years.

Another possible option is to roll over the inherited IRA assets into your own IRA. The rollover is exempt from current tax liability if completed within 60 days. Best approach: Use a "trustee-to-trustee" transfer to avoid tax withholding on the distribution from the IRA.

Nonspouse beneficiaries: If you have inherited an IRA from someone other than a spouse, you cannot treat the IRA as your own. Thus, you are neither permitted to make subsequent contributions to the inherited IRA, nor can you roll over the funds to your own IRA. However, you can still arrange a trustee-to-trustee transfer to another IRA maintained in the name of the deceased IRA owner, with you as beneficiary. You must begin taking RMDs subject to the rules for IRA beneficiaries. (Remember, RMDs are suspended for the 2009 tax year.)

Distributions from an inherited IRA are taxed at ordinary income rates. (The maximum tax rate for 2010 is 35%.) If you fail to take an RMD, you must pay a penalty tax equal to 50% of the required amount of the distribution.

Be aware that this article only summarizes the main rules when you are the sole beneficiary. You must also be careful that the IRA is properly titled. In addition, other rules may apply when a Roth IRA is inherited. Contact a tax professional for assistance.

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