A child or non-spouse inherits
Now, take the case of inheritors who are not spouses. Say you're a child receiving an IRA from a parent. You cannot roll the money into an IRA in your own name. If you decide to cash out, two bad things happen: (1) You'll owe income taxes, if it's a traditional IRA. (2) You will lose the glorious, multiyear (even multi-decade) tax shelter that an inherited IRA can provide.
So you, too, should retitle the account as an "inherited IRA." For example, say John Jones leaves his IRA to his daughter, Joan. Joan should retitle it "John Jones IRA (deceased Aug. 1, 2012) for the benefit of Joan Jones, beneficiary." If the money will be divided among heirs, each recipient should retitle his or her share. Every year, you're required to make a minimum withdrawal, based on your age, but can take more if you want. Remember, withdrawals are taxed; the rest accumulates tax-deferred.
Now let's say that Joan dies, naming her son, Jack, as beneficiary. Jack can retitle the account as an inherited IRA and complete the withdrawals on the same schedule that Joan began. The family tax deferrals could last for decades more!
What if you inherit a 401(k)? That, too, can be retitled as an inherited IRA.
Correct titling is critical, says James Lange, author of Retire Secure! Pay Taxes Later. If you get it wrong, you'll be taxed immediately, on the whole amount. The lawyer who handles the will can help heirs retitle. Or send a letter to the mutual fund group that holds the IRA, specifically asking that it create a separate "inherited IRA" for each beneficiary.
Bottom line: Anyone holding an IRA or 401(k) should leave a note explaining the importance of retitling. You want your heirs to get as much tax deferral as they can from the money you leave them.
Jane Bryant Quinn is a personal finance expert and author of Making the Most of Your Money NOW. She writes regularly for the Bulletin.