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.
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.
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.