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Financially Speaking

How to Handle Inherited IRAs

Save big on taxes when giving or receiving an individual retirement account

Do you have an individual retirement account (IRA) that you're leaving to your kids? Or — flip that — do you expect to inherit an IRA? Read this column carefully. It could save you a ton of money in income taxes.

Mistakes are painfully common when IRAs are passed to heirs, says Ed Slott, author of The Retirement Savings Time Bomb … and How to Defuse It. One wrong move and the entire IRA will be taxed rather than tax-deferred. Even financial professionals don't always know the rules, Slott says.

An IRA's greatest gift is long-term tax shelter. The money you put in the plan is invested in mutual funds. All the earnings — interest, dividends and capital gains — grow tax-deferred. With traditional IRAs, your heirs will owe income taxes when they take money out of the account. With Roth IRAs, the money comes tax-free. In either case, the best strategy for heirs is to leave as much money as possible in the account. The tax-sheltered growth of those investments could continue for years, even decades. Here's what you and your heirs need to know.

A spouse inherits

Let's start with the easiest case: You're a spouse who inherits an IRA from your husband or wife. You can put the IRA in your own name ("retitle" it) — that's the simplest way — or roll the money, tax-free, into a new IRA, also in your name.

If it's a traditional IRA, you can leave the money alone until you reach age 70-1/2, when required withdrawals begin. With a Roth IRA, any money you don't need can stay in the Roth for the next generation.

There's a tax wrinkle for younger spouses. If you need some of that IRA money, you'll potentially owe a 10 percent penalty, as long as you're under 59-1/2. You can avoid the penalty, however, by retitling the account as an "inherited IRA."

The rules on retitling are very specific. As an example, say that John Jones dies, leaving his IRA to his young wife, Mary Jones. The account should be retitled "John Jones IRA (deceased Aug. 1, 2012) for the benefit of Mary Jones, beneficiary." Once that's done, Mary can start taking money, penalty-free.

illustration of person walking the tightrope of balancing IRA as inheritance

Balancing an inherited IRA and avoiding heavy taxes is like walking a tightrope. — John Ueland

There's one more step — younger wives, please note. When Mary reaches age 59-1/2, she should retitle the account again, this time in her name alone. That lets her defer any further withdrawals until she reaches 70-1/2. If she doesn't take this step, withdrawals must start when her late spouse would have reached 70-1/2.

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