Suppose your spouse dies on or after April 1 of the year after turning 70 1/2. In this case (assuming you are the sole designated beneficiary of your deceased spouse's traditional IRA (or SEP) account), here are your options:

Option No. 1: Treat Inherited Account as Your Own
Under this option, you choose to treat the account inherited from your spouse as if it had always been your own account. This is almost always the tax-smart way to go.

First, however, you must take out your deceased spouse's required minimum withdrawal for the year of death. Only after that mandatory withdrawal has been taken can you claim the account as your own.

Example 1:
Say your husband died this year. You are the sole designated beneficiary of his traditional IRA (or SEP) account. Before you can treat the account as your own, you must take out the minimum withdrawal for this year (the year your husband died). Calculate that amount as if your husband were still alive at year end. Then withdraw the calculated amount (or more) by Dec. 31 of this year. (Be sure to reduce the minimum withdrawal amount by any withdrawals taken by your husband this year before he died.)

Next, you should designate the account as your own, by retitling it to show you as the owner rather than the account beneficiary. (You should do this as soon as possible, and at the latest by December 31 of year after the year of death.) If you are under 70 1/2, you aren't required to take any further minimum withdrawals until after reaching that age. If you are over 70 1/2, your next minimum withdrawal must be taken by Dec. 31 of the year after the year your spouse dies. You should calculate the amount of that minimum withdrawal and the required withdrawals for subsequent years using the new rules, as if you were the original account owner.

Option No. 2: Leave Account in Your Deceased Spouse's Name
Under this option, you simply leave the traditional IRA (or SEP) account in your deceased spouse's name. This is generally not the most tax-efficient way to handle an inherited IRA, but as you might suspect, it requires minimal paperwork.

The problem with this option is that your annual minimum withdrawal calculations are made using your single life-expectancy figure as the divisor. In contrast, if you choose option No. 1, you are allowed to use a longer joint life-expectancy figure. That means a bigger divisor, lower minimum withdrawal amounts, and lower taxes. So I recommend option No. 1 in almost all cases.

That said, if you use option No. 2, you must first calculate the minimum withdrawal amount for the year of death. Do this as if your spouse were still alive at year end. For subsequent years, minimum withdrawals are calculated based on your single life expectancy.

Example 2:
Your husband passed away in 2005. You are the sole designated beneficiary of his traditional IRA. Under the rules just explained, you must take a minimum withdrawal by Dec. 31 of 2005. To calculate the amount, follow the new minimum withdrawal rules for original account owners. Specifically, use the joint life-expectancy divisor based on the age your husband would have been had he still been alive at the end of 2005. By Dec. 31 of 2006, you must take another minimum withdrawal.

To calculate the proper amount you must first determine the appropriate life-expectancy divisor to use. For the 2005 withdrawal, this depends on your age at the end of 2005. Let's say you'll be 68. Use Table I of Appendix C in IRS Publication 590 (Individual Retirement Arrangements) to find the single life-expectancy divisor for a 68 year old, which happens to be 18.6 years. Now divide the year-end 2004 account balance, say $250,000, by 18.6 to come up with your 2005 minimum withdrawal amount of $13,440. Take out that amount (or more) by the end of 2005 to avoid the 50% penalty. Your 2006 minimum withdrawal must be taken by the end of that year. The amount will equal the year-end 2005 account balance divided by 17.8 (the life expectancy divisor for a 69-year old). Repeat this process for each subsequent year for as long as you live.

Here's an important point. You can switch over to option No. 1 at any time after taking the minimum withdrawal for the year your spouse dies. If you make the switch to option No. 1, you can then follow the more taxpayer friendly rules for original account owners.