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.
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.