Most of us know about IRAs, about how we can put aside money each year into an account that gives us a tax deduction this year, leaving the money to grow tax deferred until we are ready to take it and spend it during retirement. What many folks don’t know is what happens to that money if it hasn’t all all been withdrawn when the IRA owner dies. What happens to that money next?

Most of us also know that when we open and maintain an IRA, somewhere in the paperwork are the names of people whom we designate as beneficiaries. These are typically people close to us whom we name to receive the proceeds of these accounts. The rules are different depending on whether the named beneficiary is a spouse or a non-spouse.

This post is more about a non-spouse beneficiary. Properly dealing with an inherited IRA can be tricky business. If you take the right steps, you can continue to delay taxation on the account for many years. But if you make a mistake, the entire account balance could be taxable immediately — thereby wasting a potentially huge sum of money on taxes.

Each year, beginning in the year after the death of the original account owner, you’ll have to take what is known as a Required Minimum Distribution from the account. We use the term RMD for short. The idea is to distribute the balance of the account over the remaining life expectancy of the beneficiary. The actual calculations are best explained with an example.

Imagine that your mother passes away in 2010, leaving you, as her only child, the entire IRA. Obviously, you are not a spousal beneficiary. If she was old enouth to be subject to the RMD rules in 2010 but had not yet withdrawn it, you’ll be required to take her RMD for her — calculated in the same way it would be if she were still alive.

Beginning in 2011, however, RMDs from the account will be based on your life expectancy. If on your brithday in 2011, you become 56 years of age, your remaining life expectancy is 28.7 years, according to the IRS Life Expectancy Tables. As a result, your RMD for 2011 will be equal to the account balance as of 12/31/2010, divided by 28.7. Each later year, since your life expectancy drops by one, you become subject to a new RMD, which is the number you started with less 1. In this case, your RMD for 2012 will be equal to the account balance on 12/31/2011 divided by 27.7.

The IRS has a mandate to set in place the rules about taxation since they are charged with collecting from those of us subject to those rules, the necesary money to run the government. Since the money accumulating in an IRA has never been taxed, their job is to somehow follow up and make sure we pay our share. But long ago a Supreme Court justice declared that it was not a citizen’s responsibility to pay more taxes than was required. It is, however, your responsibility to know the rules and to pay what you are supposed to pay and at the same time, avoid paying more than you have to. This is one of those tricky cases that can lead to confusion.

If you want to know more, reply to this post and we’ll get you an answer.