Inherited 403b Tricky Question

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Topic Author
Beowulfto
Posts: 25
Joined: Wed Mar 05, 2014 12:30 am

Inherited 403b Tricky Question

Post by Beowulfto » Fri Jul 31, 2020 10:51 am

Earlier this year I received a call out of the blue from an employee of one of my parents former employers (parent passed away 10 years ago). They had received a form letter addressed to my parent that referenced an account with Fidelity. A few phone calls later it was determined that my parent had established a 403b retirement account and my sibling and I are the named beneficiaries. Since learning of this I have been doing research on how best to manage this surprise windfall. Yesterday I was informed of the value of the account, so with firm numbers I can now plan the best course of action. I hope that some on this board may have encountered a similar issue and can critique my current plan. As a non-spouse beneficiary of a 403b, it would seem my options are 1) to take full disbursement and pay regular income tax on the sum (they will auto withhold 20%), 2) I can roll it over into an Inherited IRA and then take disbursement over 5 years, or 3) I can roll over to an Inherited IRA and take the RMDs based on my age. The tricky thing is, because my parent passed away 10 years ago, I have missed the RMDs for the last decade (through no fault of my own) and now owe a penalty of 50% of all missed RMDs. In my research I ran across the following in a T. Rowe Price document: "If you fail to take the required minimum distribution or take a distribution that is too small because of a reasonable error and you take steps promptly to correct it, you may ask the IRS to refund the penalty tax. IRS Form 5329 and a letter of explanation are required for this process." While I don't have the specifics of the account value from 10 years ago (I would need to request that they be generated), I estimate that based on the current value and my age, my tax penalty would be around $5000. So here are my current thoughts on the best course of action for best tax advantage and simplicity:

Take full disbursement this year and pay regular income tax (currently in 12% bracket)
Maximize 401k contributions and IRA contributions for myself and spouse to reduce taxable income.
Open a Donor Advised Fund and fund with the amount that I calculate will keep us out of the 22% bracket. We normally donate a sizable amount of our income, so this would just shift the source of our giving and also allow us to bunch our donations in future years to take advantage of tax deductions.

A few questions that I hope someone has an answer for:
If I file Form 5329 and try to do everything by the book, will I then have to refile the last 10 years of tax returns with a 5329 for each, or could I just file one 5329 for 2020 and include what I calculate to be all the missing RMD 50% penalties?
If I take the full disbursement and just pay regular income tax this year (not filling out Form 5329 and paying the penalty), am I asking for problems with the IRS? I would have made the RMDs if I had been aware of the account 10 years ago when my parent passed. Just don't want to open a can of worms.

I know this is a good problem to have, I just want to make the best of it without getting too complicated. Thank-you in advance for your input, I have learned so much from the experience on this forum!

Alan S.
Posts: 9792
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: Inherited 403b Tricky Question

Post by Alan S. » Fri Jul 31, 2020 11:34 am

Beowulfto wrote:
Fri Jul 31, 2020 10:51 am
Earlier this year I received a call out of the blue from an employee of one of my parents former employers (parent passed away 10 years ago). They had received a form letter addressed to my parent that referenced an account with Fidelity. A few phone calls later it was determined that my parent had established a 403b retirement account and my sibling and I are the named beneficiaries. Since learning of this I have been doing research on how best to manage this surprise windfall. Yesterday I was informed of the value of the account, so with firm numbers I can now plan the best course of action. I hope that some on this board may have encountered a similar issue and can critique my current plan. As a non-spouse beneficiary of a 403b, it would seem my options are 1) to take full disbursement and pay regular income tax on the sum (they will auto withhold 20%), 2) I can roll it over into an Inherited IRA and then take disbursement over 5 years, or 3) I can roll over to an Inherited IRA and take the RMDs based on my age. The tricky thing is, because my parent passed away 10 years ago, I have missed the RMDs for the last decade (through no fault of my own) and now owe a penalty of 50% of all missed RMDs. In my research I ran across the following in a T. Rowe Price document: "If you fail to take the required minimum distribution or take a distribution that is too small because of a reasonable error and you take steps promptly to correct it, you may ask the IRS to refund the penalty tax. IRS Form 5329 and a letter of explanation are required for this process." While I don't have the specifics of the account value from 10 years ago (I would need to request that they be generated), I estimate that based on the current value and my age, my tax penalty would be around $5000. So here are my current thoughts on the best course of action for best tax advantage and simplicity:

Take full disbursement this year and pay regular income tax (currently in 12% bracket)
Maximize 401k contributions and IRA contributions for myself and spouse to reduce taxable income.
Open a Donor Advised Fund and fund with the amount that I calculate will keep us out of the 22% bracket. We normally donate a sizable amount of our income, so this would just shift the source of our giving and also allow us to bunch our donations in future years to take advantage of tax deductions.

A few questions that I hope someone has an answer for:
If I file Form 5329 and try to do everything by the book, will I then have to refile the last 10 years of tax returns with a 5329 for each, or could I just file one 5329 for 2020 and include what I calculate to be all the missing RMD 50% penalties?
If I take the full disbursement and just pay regular income tax this year (not filling out Form 5329 and paying the penalty), am I asking for problems with the IRS? I would have made the RMDs if I had been aware of the account 10 years ago when my parent passed. Just don't want to open a can of worms.

I know this is a good problem to have, I just want to make the best of it without getting too complicated. Thank-you in advance for your input, I have learned so much from the experience on this forum!
First, you need to determine if your parent passed prior to their RBD (required beginning date) or after. It would always be prior if parent was still working for the plan sponsor when they passed. After determining this, if they passed PRIOR to the RBD, find out if the plan provisions defaulted to the 5 year rule or not. If so, then a lump sum distribution is required, and you can file a 5329 for the end of the 5 year period, and another for this year requesting waiver of the penalty for reasonable cause. Under your circumstances the IRS will waive the penalty.

If parent passed on or after the RBD, you should be able to make up each year's RMD and file a 5329 for each year. This is more work since you will somehow have to determine the year end balance for each year, instead of just for the 5th year after DOD. But if the balance is large enough to make this effort worthwhile if even possible, this will preserve the life expectancy stretch. The stretch must be based on the OLDER of the two of you since separate accounts were not created by the deadline. You would therefore each use the same initial divisor and reduce it by 1.0 for each successive year.

Since 403b RMDs can be aggregated like IRA RMDs, if you inherited any other 403b from your parent and took larger than minimum distributions, the excess distributions from the other account would cover the RMDs for this account, and you might have a lower delinquent RMD total. This is unlikely, but certainly possible.

With respect to withholding, since RMDs are NOT eligible for rollover, there is no mandatory 20% withholding. The default rate is 10%, but you may be able to waive that if you want. If the 5 year rule did not apply and you make up the delinquent RMDs, you are eligible to do a direct rollover of the remainder 403 balance to an inherited IRA and continue RMDs from there, or even to an inherited Roth IRA if that were beneficial for you. Taxes would be due in that event, and RMDs would have to continue from the inherited IRA or inherited Roth IRA. To be clear, if the 5 year rule applied, you cannot roll any of the account to an IRA, you must take a lump sum distribution.

Finally, with respect to what you quoted from TRP, you would not be filing a 5329 for a refund because you should not pay the penalty in the first place unless you intend NOT to request the waiver. Therefore, there will not be a refund, but a waiver granted instead. Be careful with the 5329, it's only 4 lines but the entry is not intuitive. Check the last page of the 5329 Inst. for what to put on each line.

Topic Author
Beowulfto
Posts: 25
Joined: Wed Mar 05, 2014 12:30 am

Re: Inherited 403b Tricky Question

Post by Beowulfto » Sat Aug 01, 2020 7:37 pm

Thank you Alan S for your feedback. I appreciate your clarification regarding how to deal with the 5329. I will read and fill it out carefully :D My parent did pass before the RBD, so I understand that it defaulted to the 5 year rule. I plan to take the lump sum payout and file the 5329 asking for waiver of the penalty for reasonable cause, then minimize my taxable income for the year (maximize the tax advantaged savings and utilize the DAF as I described) to the best of my ability. Anyone else see any concern or opportunity to improve my approach? Thanks again for your response and insight!

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CyclingDuo
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Joined: Fri Jan 06, 2017 9:07 am

Re: Inherited 403b Tricky Question

Post by CyclingDuo » Sun Aug 02, 2020 8:43 am

Beowulfto wrote:
Sat Aug 01, 2020 7:37 pm
Thank you Alan S for your feedback. I appreciate your clarification regarding how to deal with the 5329. I will read and fill it out carefully :D My parent did pass before the RBD, so I understand that it defaulted to the 5 year rule. I plan to take the lump sum payout and file the 5329 asking for waiver of the penalty for reasonable cause, then minimize my taxable income for the year (maximize the tax advantaged savings and utilize the DAF as I described) to the best of my ability. Anyone else see any concern or opportunity to improve my approach? Thanks again for your response and insight!
You could also make sure you are maxing out all of your current pre-tax retirement accounts to have your taxed income as low as possible to help absorb the ordinary income bump that the lump sum RMD will create. If that helps keep you under the threshold for your household to also contribute the max to both of your Roth IRA's, then you can shovel some of the money to hit your maximum allowed contribution for 2020 into Roth IRA's to more or less treat that portion of the lump sum RMD like a Roth conversion so after paying taxes on the distribution for tax year 2020, you don't have to pay taxes on the portion you were able to stuff into Roth IRA's again.

We both inherited tIRA's from our parents before the laws recently changed, so are using them as stretch IRA's over a longer time period which require us to take the minimum RMD each year, so we keep taxable income as low as possible by utilizing all of our pre-tax deductions (401k, 403b, 457b, mandatory pension contribution) and in essence convert those RMD's after paying taxes on them, and shovel the money over into the Roth IRA side of the portfolio. You at least, if you take it as a lump this year, could utilize that strategy for this year to fund your 2020 Roth IRA's if you qualify after paying taxes on the lump sum and the penalties.

Good lesson to learn for your own offspring to keep the beneficiary information up to date, a will and document that lists location of all of your assets and beneficiaries with current addresses and contact information.

CyclingDuo
"Everywhere is within walking distance if you have the time." ~ Steven Wright

Topic Author
Beowulfto
Posts: 25
Joined: Wed Mar 05, 2014 12:30 am

Re: Inherited 403b Tricky Question

Post by Beowulfto » Mon Aug 03, 2020 1:16 pm

Thank you CyclingDuo for the response. I am planning to max out our tax advantaged space this year (401k, new 403b, and IRAs) to reduce our taxable income and am also looking at using a Donor Advised Fund to further reduce the tax burden. I have been so focused on minimizing taxable income to stay below the next bracket that I hadn't considered contributing to the ROTH IRA vs tIRA, so thank you for that suggestion. I will need to consider that, as a rising concern is the increasing balance in our 401k and what RMDs will mean to our tax liability in retirement. Our ROTH IRAs have been neglected lately due to allocation of funds.

As for record keeping, yes, this has been a valuable lesson and my spouse is very kindly reminding me that our "Death Folder" needs updating. Thanks again for your time and input!

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