IRAs are useful tools to save for retirement, but many IRAs don’t get spent down completely before the accountholder passes away. If you’re named as beneficiary on an IRA, there are five things you really need to know about your inherited IRA:

  1. Spouses can roll over inherited IRAs into their own IRA.
  2. Any beneficiary can elect to take a lump sum.
  3. If the deceased IRA accountholder hadn’t yet started taking required minimum distributions, then beneficiaries can use the five-year rule to delay withdrawals.
  4. Stretch IRA strategies let many nonspouse beneficiaries extend withdrawals throughout their lifetime.
  5. Nonspouse beneficiaries can’t convert an inherited IRA to a Roth.

Let’s look at these rules more closely.

Retirement jar.

IMAGE SOURCE: GETTY IMAGES.

1. The easy way for spouses to inherit IRAs

Those who are married most often name their spouses as their IRA beneficiary, and so the laws governing IRAs make it easy for spouses to inherit IRAs. A surviving spouse can simply take the deceased spouse’s IRA and roll over the money into the surviving spouse’s own IRA. Usually, this is the best move, because it makes future planning easier and allows the surviving spouse to pool retirement assets going forward. However, spouses can use any of the options available below to nonspouses as well if they so choose.

2. Lump sums are always available

Any IRA beneficiary can take a lump sum of the account assets in one fell swoop. This is the simplest option for nonspouse beneficiaries, and if the account balance is small, then it might make more sense than the more complicated options discussed below. However, the net impact is to close the book on the tax benefits that the IRA produced. Traditional IRA withdrawals will be immediately includible in your taxable income, and Roth IRA withdrawals will lose you the ability to continue to use the account to generate tax-free income in the future. However, with inherited IRAs, there’s no penalty for early withdrawal even if the heir isn’t yet 59 1/2 years old.

3. The five-year rule for certain inherited IRAs

In cases in which the IRA holder hadn’t yet started taking required minimum distributions before death — which is typically required at age 70 1/2 — beneficiaries have the option to let the inherited IRA assets remain within the account for up to five years after death. At that point, the full amount of the IRA must be withdrawn. This limited delay allows you to do some tax planning, and there can be a real benefit to extending the deadline five years if you believe that your income will drop dramatically and make the tax burden of a traditional IRA withdrawal less onerous.

4. Stretching out an inherited IRA

An even better option for nonspouse beneficiaries involves what’s known as a stretch IRA strategy. This method requires that you start taking distributions every year, on an annual basis. How much you take out depends on two things: the value of the account at the beginning of the year, and the life expectancy of the beneficiary as of the death of the original IRA holder. This IRS chart will determine the appropriate life expectancy number.

For instance, if a 47-year-old person inherits an IRA, the appropriate life expectancy factor is 36 years. Therefore, under the stretch IRA rules, the person will need to take out 1/36 of the beginning account balance for the year. The next year, the required minimum distribution will be 1/35 of the updated accounted balance at the beginning of that year. Subsequently, the RMDs will be 1/34, 1/33, and so on. This gives you the maximum time to enjoy IRA-related tax benefits like deferral for traditional IRAs or tax-free income for Roth IRAs.

5. There are some things you can’t do with inherited IRAs

Finally, inherited IRAs have limitations. If you inherit a traditional IRA, you’re not allowed to convert it to a Roth IRA. Instead, the character of the IRA at the death of the original accountholder determines its nature as an inherited IRA. The exception is that when spouses use their option to roll over an inherited IRA into their own IRA, they can then do a Roth conversion if they choose.

It’s complicated to inherit an IRA, but these rules are the most important in figuring out how to manage a retirement account going forward. By understanding them, you can make the most of your inherited IRA for years to come.