It's terrific that your SIL adores your son and vice versa, and I know you don't want to jeopardize that. It's great for kids to know extended family. But it's not "coming off as a witch" to say to her, very calmly and when he is not around, that his habit of repeating things has already created one incident that you found embarrassing and you are asking her to stop. Emphasize how you value her help, and how very important she is to him and how much you need and want her to help you out with his development: He's at a stage where he loves, loves, loves to get attention, which is natural, but he doesn't know yet about the difference between positive attention for his appropriate behavior and negative attention for inappropriate behavior. He needs ALL the adults in his life, not just you, to reinforce the difference. If he can imitate things you think are inappropriate, then he has the skills now to imitate better things like songs or little rhymes that will be adorable coming from him -- and will help teach him language skills too.
Is your husband (assuming here he's her brother) with you on this? You need a united front about it; if he undermines you with his sister by giggling along with the imitations or saying "Oh, honey, lighten up," you and he need to get on the same page and he needs to take you seriously (I hope he does already).
Finally, I'm troubled that she thinks "You're retarded" is funny. Ask anyone who has someone in their family with developmental disabilities if the word "retarded" is funny to them. If he uses terms like that by the time he's in preschool, you likely will hear about it from his teachers. Your SIL might say "It's not cursing, don't be so PC," but it is very insensitive. To him it's just a meaningless word that gets a laugh (and a "That's not a word we use" would be much better than a laugh from the grown-ups), but soon, when he says it to another kid at a playdate etc. you could have explaining to do when other parents question it. Something to think about as you listen to her interacting with him. Good luck.