Dgab, the original question indicated that beneficiary was not the decedent's spouse and the IRA was already cashed out, so under those circumstances your Option 1 is not possible. Your Option 2 is the only option in that case and filing Form 5329 is required to request waiver of any excess-accumulation penalty if the distribution was made more than 5 years after the the end of the year of death of the decedent.
If the IRA was not already cashed out, transfer (not distribution and rollover) to an inherited IRA for the benefit of the designated beneficiary would be possible. Default treatment in the tax regulations is RMDs based on life-expectancy, so as long as the IRA custodial agreement did not dictate the 5-year rule under these circumstances, distributions based on the life-expectancy of the designated beneficiary can generally be restored by making up the missed distributions and filing Form 5329 for each year that a life-expectancy RMD was made late, requesting waiver of the excess-accumulation penalty on each.
