Most retirement savers fully expect to spend all of their savings after they retire. Yet more often than you'd think, people die with money left over in their IRAs. The IRA beneficiaries then have the right to take distributions from those accounts, but it's essential to understand the impact those withdrawals have on their taxes in order to choose the best option for them. Below, we'll look at the rules that govern inherited IRAs and what you need to do to make the best decision.

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The simple solution that spouses can use

In setting up the rules for inherited IRAs, lawmakers knew that for married IRA accountholders, leaving money to a surviving spouse would be the most common decision. With that in mind, they made the inherited IRA rules for spousal beneficiaries very simple: The surviving spouse has the right to the deceased spouse's IRA and roll it over into the spouse's own IRA. This typically gives the surviving spouse the maximum flexibility in how to manage retirement money effectively and efficiently. From that point onward, the inherited IRA money is considered to be identical to the surviving spouse's own retirement savings, including all the rules that govern minimum distributions and other requirements.

However, spouses can also use any of the options described below. Occasionally, that produces a better result, but more often than not, a simple spousal rollover is the best move.

2 main options for all beneficiaries

If you're not the surviving spouse, then your options are more limited. Those who inherit an IRA generally have two options. If the IRA holder hadn't yet turned age 70 1/2, then the beneficiaries can take out the entire balance of the inherited IRA within the first five years after the death of the original accountholders. Alternatively, they can start taking taxable distributions on an annual basis, with the size of those distributions determined by the life expectancy of the beneficiary at the death of the IRA holder.

The benefit of the five-year rule is that you don't have to touch the inherited IRA money until the end of the five-year period. That can be especially advantageous for inherited traditional IRAs, because distributions from those accounts are required to be included in the taxable income of the beneficiary. Delaying as long as possible can produce savings from tax deferral. Again, though, it's only available if the accountholder hadn't started taking required distributions from the IRA.

How life expectancy-based distributions work

The life expectancy method can produce even better results over the long run. With this method, you look up your life expectancy in the appropriate IRS table. Then, you have to take out that fraction of the account that corresponds to the remaining life expectancy.

As an example, say that you inherit an IRA when you're 48 years old. The balance of the account on Dec. 31 of the year prior to the IRA holder's death was $180,000. The IRS table gives 36.0 years as your life expectancy, so you'd have to take out $180,000 divided by 36.0 or $5,000 during the first year. After that, you'd take the account balance as of Dec. 31 of each year, and then divide it by the number of years remaining. So if the balance the second year had risen to $182,000, then you'd take that number and divide it by 35.0 (since one year has passed), getting a required distribution of $5,200.

Finally, one thing that heirs should understand about inherited IRAs is that their age doesn't matter in terms of any tax or penalty consequences from taking distributions. With an inherited IRA, there's no 10% penalty for taking money out before turning age 59 1/2. That's because the 59 1/2 requirement applied only to the original accountholder, not the heir. The only exception is that if a surviving spouse rolls over an inherited IRA into a spousal IRA in the surviving spouse's own name, then subsequent withdrawals are subject to penalty if made before age 59 1/2.

Inheriting an IRA takes somewhat more effort than most financial assets, because the tax issues become complicated. By being smart about your inherited IRA, however, you can make sure you take maximum advantage of tax deferral and enjoy a legacy that could last an entire lifetime.