The Widow’s Penalty: Why Tax Planning Matters

Oct 15, 2023 | Uncategorized

Guest Post: Amar Shah – (Sign up for Amar’s monthly newsletter here.)

As if adjusting to the loss of your spouse isn’t difficult enough, the surviving widow or widower is often left facing an unexpected financial burden. Due to various tax laws, the surviving spouse usually experiences not only a reduction in income, but oftentimes both higher taxes and higher Medicare costs. 

This double whammy can substantially reduce the amount of income the survivor has to meet their needs, which can actually increase after the loss of a partner. However, there are ways, by proactively managing your tax planning, that you can minimize these effects. 

Understanding the Problem

Typically, after the loss of the first spouse, overall income is reduced. This is due to a reduction in social security benefits and possibly a loss of, or a reduction in, pension benefits. Additionally, the surviving spouse may only receive a portion of the remaining assets, especially when there are children from a prior marriage.

To make matters worse, the surviving spouse may actually have increased costs, especially for the things they may have relied on the deceased spouse for. There may be a need for physical care, household support, meal service, transportation, assistance managing the finances and more. However, attempting to manage higher costs with less income is only part of the story. 

The Triple Tax Impact

1. Filing Status: 

Marginal Tax Rate: After the first year following death, the survivor now moves from the most favorable tax status of married filing jointly, to the least favorable, single tax status. This means, not only is income likely reduced, but a higher percentage of it now goes out the door to taxes. 

For instance, in 2023, a married couple earning up to $89,450 in taxable income pays a marginal tax rate of only 12%, but a single taxpayer earning only $45,00 per year is in the 22% marginal tax bracket. In this scenario, the surviving spouse loses 10% more of their already reduced income to taxes. 

Standard Deduction: Compound the change in marginal tax rates with the fact that, since the passing of the Tax Cuts and Jobs Act (TCJA), most households now file using the standard deduction. The standard deduction for married couples filing jointly is $27,700, but the survivor filing single only gets a deduction of $13,850.  This leaves the great majority of income for the survivor subject to income taxes at the increased, single tax rate.

2. Medicare Income Related Monthly Adjustment Amount (IRMAA)

The Medicare Income Related Monthly Adjustment Amount, or IRMAA as it is often called, is a surcharge that is added to the monthly Medicare Part B and Part D premiums. It is based on annual income and filing status from 2 years prior. Although this surcharge usually applies to higher income families, the survivor may be surprised to find that, due to their new filing status, their new premiums may actually be higher alone than what they paid together. 

3. Net Investment Income (NII): 

A consideration for higher net worth couples is the threshold for the Net Investment Income Tax. Oftentimes, the surviving spouse still retains the income from joint investment assets. In this case, a married filing jointly couple does not owe the additional 3.8% net investment income tax until the investment income exceeds $250,000. 

For the surviving spouse filing single, however, that threshold drops to $200,000. This surviving spouse may not only be subject to the additional 3.8% in Net Investment Income tax, but at that income level a single individual would also find themselves in a minimum 32% marginal income tax bracket. A married couple is not taxed at 32% until their income reaches at least $364,201.

Minimizing The Effects of The Widow’s Penalty – Planning Ahead

The best approach is to increase tax free income in retirement. Although not much can be done to address the income received through Social Security and/ or pensions, the biggest opportunity lies with large IRA accounts. These large IRA’s generate large required minimum distributions (RMD’s) for individuals over 73. 

These RMD’s from traditional IRA’s usually consist of entirely taxable income to the surviving spouse, thus increasing their taxable income and marginal tax bracket. By reducing or emptying the overall traditional IRA balance, RMD’s for the surviving spouse can be either reduced or eliminated. This keeps the resulting taxable income and income tax bracket down, plus all income from the Roth IRA will be received tax-free in retirement.

Minimize Large IRA’s While The Spouse is Still Alive: 

The best option is to plan ahead and reduce these taxable IRA accounts while both spouses are alive. This can be done by making higher contributions to after-tax retirement accounts during your accumulation years or by converting large traditional IRA’s and rolling them into a Roth IRA. This is called a backdoor IRA, and it allows couples who may not otherwise qualify to contribute to a Roth IRA. 

This not only continues to allow the earnings to continue to grow tax-free, it now creates a source of tax-free income in retirement, and reduces or eliminates the future taxable income from the traditional IRA. This is especially advantageous to the surviving spouse. Although income taxes will be due on the balance at the time of the rollover, the conversion can be done gradually over time to minimize the tax burden, while still taking advantage of the higher marginal tax brackets while filing jointly. 

By working collaboratively with your financial advisor, they can help you to determine whether you can benefit from this type of tax planning and the optimal amount to transfer each year to minimize the overall tax implications. Remember, the primary objective is to reduce the overall tax burden, and to make it easier on the surviving spouse later in life.

Minimize Large IRA’s in the Year of Death

When filing your last tax return as married filing jointly, you may want to maximize your tax bracket by instituting a traditional IRA rollover to a Roth IRA. Although this is probably the last thing a widow or widower wants to think about at this time, it is also the last opportunity to take advantage of the married filing jointly status. This significantly reduces the tax impact of the income, which will be taxed at the single rate in subsequent years, making rollovers much less favorable.

Minimizing IRA Taxes Through Charitable Giving

Lastly, in the case of higher net worth couples in the higher tax brackets, oftentimes the spouse does not need the annual income from the RMD to meet their needs. In these situations, the tax burden from the RMD can be eliminated by making a tax deductible contribution of the annual RMD to a charitable cause of your choice. To learn more about maximizing your impact through Charitable Giving, read 5 Tips To Maximize Your Charitable Giving.

Why Now?

First, as mentioned previously, it is optimal for tax reasons to begin the transition from traditional IRA to Roth IRA while both spouses are alive. For large traditional IRA’s, it may take several years of partial rollovers to optimize the tax savings. 

Even more urgent, the Tax Cuts and Jobs Act of 2017 (TCJA) is set to expire at the end of 2025. With that, it is uncertain yet what will happen to the tax brackets. If allowed to sunset, the rates are set to revert to pre-TCJA brackets, which are considerably higher. 

This could bring back the maximum tax rate of 39.6% and increase tax rates as much as 9.0% for some income levels. To learn more about the changes resulting from the TCJA and the full list of prior tax brackets see The Tax Policy Center.

For this reason, it would be wise to begin optimizing any large traditional IRA’s now, as there may only be 3 more filing years to reap the current benefit. The increase in tax rates would not only reduce the savings obtained from the rollover when the spouse is still alive, it would leave that surviving widow with an even higher tax burden in the future.

In Conclusion

The Widow’s Penalty poses a significant financial challenge, but proactive tax planning can ease the burden. By focusing on tax-free income in retirement and managing large IRAs, couples can secure their financial well-being and provide peace of mind for surviving spouses during difficult times.

Take action now to secure a stable financial future and ensure peace of mind for your surviving spouse. Learn more about Client First Capital’s  Robust Tax Planning Strategies and scenario analysis.