When someone dies and leaves their IRA to you, there are several steps that must be followed to the letter if you want to preserve the ability to take withdrawals over your lifetime. Failure to follow those steps could have disasterous effects.
When you inherit an IRA, you cannot roll it over into your own IRA unless you are the decedent's spouse. If you are not the surviving spouse, you have to roll the IRA into what is known as a beneficiary IRA and it is important that the new account be properly titled. If your name is Susan Jones and you are inheriting an IRA from Robert Smith, the correct way to title the new account is "Robert Smith, Deceased 12/31/2010, F/B/O Susan Jones".
WIth the account set up this way, you are now able to take distributions from the IRA over your lifetime and the first distribution has to be made by December 31st of the year following the year of the original account holder's death.
As with any withdrawal from a traditional IRA, taxes will be due on the amount distributed each year but there will be no penalties imposed if the person who inherited the IRA was under age 59 and a half. If the IRA was a Roth, distributions are still required (assuming a non-spouse beneficiary) and all distributions are tax-free.
The amount that has to be withdrawn from the account each year depends on the beneficiary's age. There is an IRS table to consult to get the divisor figure. For example, if you are age 44 when you inherit the account, your divisor is 39.8. If the balance of the account was $500,000 on 12/31/2010, your distribution would be $500,000 divided by 39.8. The next year, your divisor is decreased by 1.
Of course, when you inherit an IRA, you are also free to take the full amount as an immediate distribution. That is often a very tempting option, but the much better financial decision is to take distributions over your lifetime as this will allow the account to grow on a tax deferred basis - perhaps for decades.