David Levine, Groom Law Group, answers:
Although there is no “penalty tax” on distributions to a beneficiary from a 403(b) plan, what the widow is probably being told is that any distribution to her in cash will be subject to automatic 20% income tax withholding. This withholding will be applied to the widow’s taxes for the 2011 year (assuming the lump sum distribution is made in 2011) and, if this withholding is more than her tax liability for the year, she will be eligible to receive a refund of this excess. (This type of distribution is “income in respect of a decedent” for income tax purposes.)
Under the Internal Revenue Code, any “eligible rollover distribution” (which would appear to include the lump sum in this question) is subject to 20% mandatory withholding if it is paid directly to the person eligible to make the rollover. If the surviving spouse wishes to avoid this withholding, she could elect a direct rollover to another tax-advantaged plan or IRA, in which case, because the rollover is “direct”, no automatic 20% withholding would apply.
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.