Just because your grandpa left his IRA to you doesn't mean that Uncle Sam doesn't care what you do with it. The IRS sets specific deadlines you have to meet for taking distributions from your inherited IRA. Making sure you take the required withdrawals helps you enjoy the benefits of the distributions rather than turning over excessive amounts to the IRS.
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Five Year Rule
Generally, beneficiaries must complete distributions from the decedent's IRA before the end of the fifth year following the calendar year of the decedent's death. For example, if a decedent should die at any time during the 2013 calendar year, the five year period would start running in 2014 and end on December 31, 2018. Under this method, you can take all of the money out immediately, take out some of the money each year, or wait until the very last day to take all of the money out of the inherited IRA.
Annual Distributions Exception
If you are named as the beneficiary of the IRA, you can elect to take minimum annual distributions over the rest of your life instead of distributing the entire amount within five years. Especially if you are in your 20s or 30s and don't need the money right now, electing to spread distributions over a much longer period allows you to take advantage of the tax-sheltered growth. The distribution period used to figure the amount you have to withdraw each year depends on whether the decedent was already taking required minimum distributions (RMDs). If the decedent had not started RMDs, the distribution period is based on your age. If the decedent was taking RMDs, the distribution period is based on the longer of your life expectancy or the life expectancy of the decedent in the year of death. No doctor's visits are required to determine life expectancy. Instead, simply find the appropriate age on Table I in the appendix of IRS Publication 590.
If your spouse dies and leaves you his IRA, you can elect to treat it as your own so you don't have to take distributions from it until you reach the standard age for required minimum distributions: 70½. However, it also means that once you elect to treat it as your own, you can't take distributions without penalty until you are at least 59½, unless an exception applies. If you suffer the misfortune of losing your spouse in your 20s or 30s, consider whether you will need the money before age 59½ before rolling the entire amount into your IRA. If you want, you can take a portion as a distribution and then roll the rest into your IRA so you have enough to live on.
Penalties for Failing to Take Distributions
If you don't take distributions when you're supposed to, Uncle Sam gets very angry. Unlike most other penalties that are 10 to 20 percent, failing to take the required distribution results in a whopping 50 percent penalty on the amount you should have taken out. That means if you inherited a $40,000 IRA and forgot to take any distributions by the end of the fifth year, the IRS tacks on an extra $20,000 to your tax bill. If the IRA still has $40,000 in it by the end of the next year, another $20,000 tax bill comes your way.