The Widow’s Tax Penalty and How to Plan for it

December 15, 2020

If you are a couple filing your taxes jointly, one of you will likely file as an individual one day. Some statistics say as much as 80% of wives will outlive their husbands. The widow’s “tax penalty” or “tax trap,” as some call it, refers to the situation many surviving spouses face with having to pay more taxes in the years following their spouse’s passing. Here are some reasons why:

A Widow’s Filing Status Will Change.

Tax brackets benefit those that are married versus those that are single. Many times, widows will be receiving less income but will be pushed up to higher tax brackets. In addition to higher tax rates, widows lose half the standard deduction as a single filer, driving their tax bill higher.

For example, Dave and Jane are married and file their taxes jointly. They have around $90,000 in income, which includes $50,000 in required minimum distributions (RMDs) from their IRAs each year and $40,000 in pension benefits. Dave dies, and Jane is still required to take the $50,000 of RMDs and is now receiving $20,000 in survivor pension benefits. She is receiving $20,000 less per year but is now moved up from the 12% tax bracket as a joint filer to the 22% bracket as an individual. In addition, her standard deduction has also decreased from $27,400 to $14,050. Jane has a higher tax bill even though she’s receiving less income.

Taxes on Social Security May Also Increase.

Widows can also elect to claim their deceased spouse’s social security benefits if it’s higher than their own benefit. Taxation of Social Security benefits is based on income brackets that are more favorable to joint filers versus single. Many times, electing to receive the higher benefit pushes the taxation of those social security benefits from 50% of it being taxable to 85%.

Widow’s Medicare Premiums May Also Increase.

Widows also face the challenge of higher premiums charged for Medicare. More specifically, the Medicare surcharge that comes from Income-Related Monthly Adjustments Amount (or IRMAA). IRMAA is a higher premium charged by Medicare Part B and Part D and is based on an individual’s Modified Adjusted Gross Income (MAGI). Medicare recipients in 2020 that have incomes greater than $174,000 for joint filers or $87,000 for singles are subject to higher premiums. More expensive premiums for wealthier individuals is another reason why widows feel the crunch even further.

What Can We Do to Lessen the Impact of the Widow’s Tax Penalty?

Doing some planning while both spouses are alive is the best time to mitigate the impact of the above situations in later years. Reducing the income a widow is required to take is key in planning for their future.  First, in younger years, while gathering assets, consider accumulating a mix of both taxable and retirement assets. This will reduce the impact of future required minimum distributions on IRAs for your surviving spouse. Withdrawing funds from a taxable account at capital gains rates may leave the widow with a much better tax situation than having to withdraw it at ordinary income rates from a retirement account.

Second, consider a Roth conversion of some (or all) of your retirement assets. Even though paying taxes on the conversion may sting a bit, doing it while having the luxury of the joint filing tax brackets will leave your future widow with the option to withdraw funds from a Roth (tax-free) versus within an IRA as ordinary income. This will also reduce the required minimum distributions that may become a tax burden in the future.

Many couples plan for the day that assets will be transferred to their children; why not plan for the day that one of you will no longer be around for the other?

Please note, every individual’s situation is different; it’s important to consult a tax advisor to see what the best steps are for you.

Jenny Chung, CFP® is a Wealth Manager at BDF. She uses her background as a teacher to help individuals and families understand their investments and financial plans. She also works on the firm’s Divorce Practice Group which helps divorcing individuals navigate through the process. Jenny earned a master’s degree from the University of Illinois and has over 20 years of experience working in financial services.

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