Exposing your IRAs to taxation at inheritance time is unavoidable. The trick is to minimize taxation of your IRA when your designated beneficiary inherits your IRA, as inherited IRAs are subject to such complex tax rules.

If your IRA is set up properly and your designated beneficiary handles the inherited IRA properly, it can grow significantly and create untold wealth for your beneficiary and their families over their lifetimes.

Tax rules allow any person you designate as your IRA beneficiary to "stretch" that IRA over his or her lifetime. Stretching your IRA means extending the term of the required distributions. If your IRA designated beneficiary does not properly set up the inherited IRA, the tax rules require them to receive distributions over a five-year period beginning the year following the year of your death. If the IRA is set up properly by your designated beneficiary then instead of this five-year distribution period, the IRA can be distributed over the life expectancy of your designated beneficiary, which could be significantly longer and allow for the IRA to grow, tax deferred, over a much longer period of time.

The term "designated beneficiary" means the person you named as such when you set up your IRA. You name someone as your designated beneficiary at the time you are sold the IRA. Not naming a designated beneficiary would make your Estate the de facto beneficiary. Since your Estate is not a person and has no life expectancy, IRS rules require that the IRA be taxed to your Estate with required distributions over a five-year period. For example, if at your death your designated beneficiary is 29 years old, they can stretch your IRA over their projected life expectancy of 53.3 years, rather than the five-year period, as long as they set the inherited IRA up properly at the time of your death. This gives your IRA more room to grow, tax deferred, and better provides for your beneficiary

How do you, the beneficiary, properly set up the inherited IRA, you ask? For the IRA to be re-titled properly, and thus maintained as an inherited IRA, the IRS requires that the name of the person you inherit from (the deceased IRA owner) remain on the IRA account. Here is how an inherited IRA should be titled: "Jane Doe, IRA (deceased April 5, 2006) F/B/O John Doe, Jr., beneficiary", or "John Doe, Jr., as beneficiary of Jane Doe, IRA (deceased April 5, 2006)." The account must be maintained as an inherited IRA for the rest of the time that you hold it.

To add a further stretch to your inherited IRA, after properly re-titling your inherited IRA, you need to name a beneficiary of your own. This is called a "successor beneficiary". If you were to pass away unexpectedly then this successor of your inherited IRA can, like you, further stretch the IRA over their projected life expectancy.

Example: Stan Smith has accumulated $100,000 in his IRA. He is age 50 and has a wife, Sue Smith, age 47. Let’s assume Stan’s IRA grows at a rate of 8% per year. After 70 ½ Stan begins taking his required Minimum IRA distributions as required. At 85 Stan passes away and his wife, the designated beneficiary, inherits his IRA. Sue is 82 years old and is required to take her required minimum distributions over her life expectancy, but dies at age 92. Sue’s named designated beneficiary is her son John Smith, age 57. Based on John’s projected life expectancy his inherited IRA will be worth $3,236,841. Not bad for a $100,000 IRA!