“Will she pay ordinary income taxes if she receives a lump-sum distribution? And what about the 10% premature distribution penalty that would normally apply for distributions to individuals who have not yet attained age 59½.”  

Michael A. Webb, Vice President, Retirement Plan Services, Cammack LaRhette Consulting, answers:  

Good question! Some beneficiaries mistakenly believe that 403(b) distributions (or other qualified plan distributions, such as 401(k) distributions) are not taxable to the beneficiary since such assets, such as life insurance proceeds, generally pass directly to named beneficiaries. However, this is an incorrect assumption; 403(b) plan assets are subject to ordinary federal income taxes upon distribution to a beneficiary.   

If you think about it, this taxation makes sense, since the assets accumulate in the account without taxation and were always designed to be “tax-deferred”, not “tax-free”. Note, however, that Roth 403(b)s are not subject to any federal taxes upon receiving a qualified distribution, and a distribution to a beneficiary would be the type of distribution  that would not subject the beneficiary to federal income tax. After-tax contributions to a 403(b), would also not be taxed (since they have already been taxed, by definition), though such contributions are uncommon in 403(b) plans. Note, however, that earnings on non-Roth after-tax contributions would be subject to taxation.  

However, 403(b) distributions to a beneficiary are NOT subject to the 10% premature distribution penalty, even if the beneficiary is younger than 59½, since distributions to a beneficiary or estate are an exception to the penalty (note: the IRS provides a handy list of exceptions to the penalty as well as an explanation of the penalty itself, at IRS Tax Topic 558 http://www.irs.gov/taxtopics/tc558.html).  

 Of course, the beneficiary need not take a lump-sum distribution of her mother’s 403(b) balance. She can maintain the assets in the 403(b) plan as an inherited 403(b) if the terms of the plan permit it, and take distributions in the future, again subject to ordinary federal income taxes, but no 10% premature distribution penalty. Like any other 403(b) plan assets that are eligible for distribution, she can also roll over the 403(b) into an IRA account; however, it must be an inherited IRA in her name, as beneficiary of the deceased participant. If the beneficiary wishes to preserve tax deferral of 403(b) assets, she should consult with a tax advisor well versed in such matters for discussion of the various options, which are beyond the scope of this column.  

You may have noticed that the Experts did not mention state or estate taxes; this was intentional, as the taxation of death benefit distributions varies by state and estate taxes are beyond the scope of this article; beneficiaries should contact their tax advisers to address any state or estate taxation issues.