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The Widow’s Penalty Tax and How to Avoid It

Published on: Oct 28 2020

The widow’s penalty tax is one of the least known yet most onerous of the retirement Stealth Taxes.Since few people are aware of it, few retirement plans defend against the widow’s penalty. I frequently warn people about the solo years. Those are the years after one spouse has passed away. The surviving spouse must maintain the household with one less Social Security benefit and perhaps a decline in other income. In addition, expenses are likely to increase because the surviving spouse needs help the deceased spouse used to provide.

Perhaps what’s least known about the solo years is that income taxes are likely to be substantially higher for the surviving spouse.The solo years often are when retirement plans fall apart and the surviving spouse struggles. The widow’s penalty tax is a major reason.Here’s how the widow’s penalty works. When both spouses are alive, the couple’s tax return filing status is “married filing jointly.” But after one spouse passes away, the surviving spouse’s filing status changes to single. The married filing jointly status is the most beneficial while the single filing status is unfavorable.

Taxpayers who are married filing jointly stay in the 12% tax bracket until their taxable income exceeds $80,250 in 2020. But a single taxpayer stays in the 12% bracket only until taxable income exceeds $40,125. The 22% tax bracket applies to a married couple filing jointly until taxable income exceeds $171,050 but for a single taxpayer the ceiling is taxable income of $85,525.

A surviving spouse is allowed to use the married filing jointly status only for the year in which the other spouse died. The special surviving spouse status can be used for a few years but only if there is a dependent child in the household.You can see the surviving spouse is hit with a double whammy.

First, as I mentioned earlier, income is likely to decline. The household begins receiving only one Social Security check instead of two. Other sources of in-come also might decline. For example, the deceased spouse might have been receiving a pension or annuity that upon his or her death either ends or pays a reduced amount to the surviving spouse.

Second, the surviving spouse is pushed into a higher tax bracket. The income usually doesn’t decline enough to keep the surviving spouse in the same tax bracket as a single taxpayer. That would require the income to be cut in half. Instead, the surviving spouse loses some income but also pays a high-er income tax rate on the remaining income because of the change in filing status. Income declines, but income taxes increase.

There can be a third hit to the surviving spouse. Higher-income Medicare beneficiaries are subject to the Medicare premium surtax, also known as income-related monthly adjustment amount (IRMAA).

As with income taxes, the Medicare premium surtax changes with marital status. A single taxpayer with the same income as a married couple will pay twice the Medicare surtax as the couple. A newly widowed taxpayer who retained a high percentage of the couple’s previous income could pay as much or more in the Medicare premium surtax as the couple paid jointly.

A fourth negative effect of the solo years is that Social Security benefits are included in gross income at a faster rate for a single taxpayer than for a married couple filing jointly.Too often both spouses in a married couple believe their retirement finances are in good shape. But they haven’t done the math to see what happens after one spouse passes away. Most of the time, income declines while taxes and other expenses rise. The taxes can increase substantially on the same or even a lower income after one spouse passes away. In general, it doesn’t matter which spouse passes away first. The results are very similar for either spouse.

Many people downplay the widow’s tax, believing it will last for only a short period. Yet, the data show that in 75% of married couples one spouse will outlive the other by at least five years. In about 50% of couples, one spouse will outlive the other by at least 10 years.Married couples need to plan for the widow’s tax penalty and other difficulties of the solo years.

Be sure to run the numbers and learn the potential extent of the problem. Estimate how much income will decline after one spouse passes away. Then estimate how much taxes and other expenses will increase, while estimating the taxes using the change to single filing status.

Don’t forget to estimate the Stealth Taxes, such as the Medicare premium surtax and taxes on Social Security benefits.Then, plan for the widow’s penalty tax. You might decide to spend less in the preceding years to ensure more money is available for the solo years. Some people will buy permanent life insurance to provide a lump sum of tax-free cash to the surviving spouse.

Another strategy is to increase future tax-free income. The widow’s penalty tax and the other Stealth Taxes of the solo years are good reasons to consider converting a traditional IRA to a Roth IRA now. Pay the taxes now at the lower married filing jointly rate to provide tax-free income in the future when the surviving spouse is likely to be in a higher income tax bracket as a single taxpayer.

Remember that if a lot of money is in a traditional IRA or 401(k), the surviving spouse will have to take required minimum distributions, and the percentage of the nest egg that must be distributed increases each year.

Having a traditional IRA or 401(k) could force a lot of money to be distributed when the surviving spouse is in a higher tax bracket.Another option is for the surviving spouse to disclaim all or part of the inheritance of a traditional IRA or 401(k), as we discussed in the October 2020 issue. A disclaimer transfers the assets and income to other family members who might be in lower tax brackets and have employment income to help pay the taxes.

Of course, this assumes the surviving spouse has sufficient income and other assets to maintain the standard of living. There is a range of actions that can be taken to mitigate the widow’s penalty tax. It is important to recognize the situation and plan for it, instead of leaving the surviving spouse to deal with the consequences.



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