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When an IRA owner passes away, that person's account beneficiaries receive what is known as an inherited IRA. Inherited IRAs behave differently than IRAs you contribute to yourself. If you receive an inherited IRA, you need to understand the basics of how they work in order to best put that money to work for you.

The options you have available to you as the recipient of an inherited IRA depend on a handful of key factors:

  • Whether the IRA was a Roth IRA or a traditional IRA;
  • How old the original account owner was when he or she passed away; and
  • Whether you were married to the person who owned the account at the time that person passed away.

What you can do with an inherited IRA
If the person from whom you've inherited the IRA was at least age 70 and a half and you inherited a traditional IRA, the required distribution needs to be taken for the original owner's year of death. Beyond that, there are three basic withdrawal methods that any beneficiary can choose in most circumstances and a fourth method available only to a spouse who inherited the entire IRA. The three basic methods are the "lump sum" method, the "life expectancy" method, and the "five-year" method.

Lump sum: In a lump sum distribution, you take all the money out of the IRA all at once. If it is a traditional IRA, you're taxed on the money at your ordinary income tax rate, but you won't face a 10% early withdrawal penalty, no matter your age. If the IRA is a Roth IRA, the earnings can be distributed completely tax-free as long as the account is at least five years old at the time of the withdrawal. 

Life expectancy: With a life expectancy distribution plan, you start taking distributions by December 31 of the year after the original owner died. Your distributions would typically be driven by the required minimum distribution table based on your age, though the deceased's hypothetical life expectancy can be used in some circumstances if it would be longer than your own. Additionally, if multiple people are named as beneficiaries, the life expectancy of the oldest beneficiary is used, unless the IRA is split up to different accounts by beneficiary before those distributions begin.

Like with the lump sum method, there are no 10% early withdrawal penalties, traditional IRA earnings are taxed as ordinary income, and Roth IRA earnings can be withdrawn tax-free if the account is at least five years old.

Five-year: Under the five-year rule, you have five years after the year of the original account owner's death to take the money out of the account. As with the other method, there are no 10% early withdrawal penalties, traditional IRA earnings are taxed as ordinary income, and Roth IRA earnings can be withdrawn tax-free if the account is at least five years old.

Note, however, that the five-year rule cannot be used when inheriting a traditional IRA if the original account owner had reached the age where required minimum distributions have started. 

Special case for spouses
Spouses have a special opportunity to treat an inherited IRA as if it were their own. To treat an inherited IRA as your own, you need to have:

  • Been married to the IRA owner at the time of his or her death;
  • Been the only beneficiary of the IRA; and
  • An unrestricted right to withdraw money from that IRA. 

By treating an inherited IRA as your own, you can do things like roll it into your own 401(k) or IRA or use your own age-based timings rather than your deceased spouse's to take distributions. If your spouse was age 70 and a half or older at the time of death and the IRA was a traditional IRA, you will still need to take the required distribution for the year of your spouse's death. Once that requirement is taken care of, the IRA would act as though it were yours.

Which method is right for you?
Which approach to take depends on your age, overall financial condition, other sources of income, and anticipated life expectancy. If you have no immediate need for the money and are young enough to let it compound, stretching the withdrawals out as long as possible can help the money grow tax advantaged for that much longer. On the other hand, if you were depending on the pension, Social Security, and/or earnings of the deceased, then the inherited IRA can help you replace at least some of that income.

In any event, if you're inheriting an IRA, it likely means you've lost a family member or another person that matters to you a great deal. You have at least a year from that person's death before you have to start taking withdrawals under any of the methods, so take some time to think it over. The decision is an important one, and one best made after you've had a chance to grieve for your losses and take care of those who remain.

Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.