If you inherit an IRA, you can pull out all the money right away. If you don’t need the cash, though, you’re better off leaving the money in the account, where tax deferral can continue. Typically, you’ll be subject to the rules on required minimum distributions (RMDs).
Suppose Mike Hawkins inherits an IRA from his uncle. Mike is 48 years old when he starts RMDs. According to the IRS life expectancy table, a 48-year-old has a 36-year life expectancy. Therefore, Mike can stretch RMDs over 36 years.
Now suppose Mike also has two traditional IRAs. One has $100,000, all from pretax contributions, and the other has $30,000, including $13,000 from nondeductible (aftertax) contributions.
Mike wants to convert $20,000 of his traditional IRAs to a Roth IRA this year. His two traditional IRAs have $130,000, including $13,000 (10%) of aftertax dollars. Thus, his $20,000 Roth IRA conversion will be 90% ($18,000) taxable and 10% ($2,000) a tax-free return of his aftertax dollars.
To make this Roth IRA conversion and calculate the income tax due, Mike can ignore the IRA he has inherited from his uncle. The inherited IRA is drawn down on one schedule; Mike’s own traditional IRAs are taxed under their own set of rules.