How do I avoid a tax penalty while letting funds grow in my 403(b) account?

by Nancy G. Montanye, CPA | Oct 02, 2017
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My niece and nephew, of whom I am guardian, inherited from their mother who passed away a 403(b) account. Both children are minors, and upon her passing, the account was transferred into their names with me as guardian. Their mom passed away May 31, 2013, and the account was not transferred to them until Jan. 5, 2015. I was just going to have the funds sit in those accounts and grow, but I am being told that if we didn't complete required minimum distributions (RMD) within two years we’d have to withdraw all the funds by the end of 2018 to avoid a 50 percent tax penalty. Is that correct? If so, will that show as income for the kids upon applying for college aid through FAFSA? How can I avoid such tax penalty or withdrawal?

Inherited plan distribution options for nonspouse beneficiaries may include: full distribution; entire account distribution by the end of five years from the death of the owner; or RMDs based on the life expectancy of the beneficiary. Many inherited qualified plans such as 403(b)s and 401(k)s do not have the distribution (or investment) options available to inherited IRAs for administrative and cost reasons. Each qualified plan has its own set of rules, many of which require a five-year payout or a lump-sum payment. IRAs allow for the setup of separate accounts for each beneficiary, whereas retirement plans often do not. Without separate accounts, RMDs are based on the life of the oldest beneficiary. To resolve these restrictions, you can make a direct trustee-to-trustee transfer of the funds from the qualified plan to an inherited IRA. The IRA must be set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary.
  
The best scenario for tax and financial aid purposes would be to keep the distributions from the retirement plan at a minimum. This would allow it to grow as much as possible on a tax-deferred basis. Retirement accounts are not counted as assets for FAFSA, although the RMD distributions are included in the income calculation.
 
The complication arises that the RMDs were not started on time, which was the year after death (2014). The argument could be made that the guardianship was not yet established, and that this deadline could not be met. I would advise asking the 403(b) plan administrator what the RMDs should have been for 2014, 2015, 2016, and 2017. Then, withdraw that amount and file a tax return with Form 5329 requesting that the 50 percent excise tax be waived, along with a letter of explanation. This way, the RMDs are withdrawn as required, with the possibility of no excise tax. Then, moving forward, each year the RMD would be withdrawn and a tax return filed. All of this is best done with the assistance of CPA who can speak directly with the IRS on your behalf if needed.

The alternative five-year payout option mentioned in your question would need to be made in 2018 at the latest. Tax planning is advised if this option is chosen. Consider taking half the balance in 2017 and the rest in 2018 to reduce the tax impact. The full amount would be taxable, and would be recognized as assets for FAFSA. In addition, these assets would generate taxable income subject to FAFSA reporting. Without knowing more specifics about the value of the accounts, and other information such as other income, it is hard to know the exact tax implications. 
 
For more resources, check out PICPA’s Money & Life Tips, Ask a CPA, or CPA Locator.

Answered by: Nancy G. Montanye, CPA, is a sole practitioner in Williamsport, Pa. 
Disclaimer
The responses are based on the limited information provided by the questioner and apply the laws and regulations at the time of posting. Other options could arise as rules and regulations may change over time, including but not limited to the passage of the Tax Cuts and Jobs Act of 2017. They are intended to provide general information, not specific accounting or tax advice; they are not intended or written to be used and cannot be used for the purpose of avoiding or evading taxes or penalties under the IRS code or regulations. Views expressed do not imply an opinion of the PICPA, its officers, directors, employees, or members.
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