The Widow Tax: What is it? And How to Avoid it

Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes.”  Oddly enough, this is the perfect quote to introduce the topic of this episode of Retirement Ready… the Widow/Widower Tax Penalty.

In order to set the stage of what the Widow’s Tax Penalty is, let me quickly run you through a scenario.  For the sake of simplicity, I have built a model that simply shows a married couple, John & Jane Taxpayer who receive Social Security and have just begun taking their Required Minimum Distributions having both turned 73 this year.  I have left all other peripheral income sources – savings interest, brokerage interest and dividends, and any realized gains out of the equation.

So here’s the Details of their situation…

John has a Social Security benefit of $52,000

Jane, receives half of John’s benefit, adding $26,000 to the household income

John’s first RMD is $53,723 or 3.77% of his $1.425 Million IRA

Similarly, Jane must take an RMD this year for the first time, and hers is $10,707 from her $284,000 IRA.

All tallied, John & Jane have a Gross Income of $142,429

After a standard deduction and the funny math around Social Security taxability, their taxable income equals $88,646.  For a Married Filing Jointly couple this puts their top marginal tax rate at 12%, leaving them with a tax bill of $10,173 an effective rate of 7.15% of their Gross Income.

What if, though, at the end of last year, John’s life came to a premature end?  Well, beyond the obvious sadness and hardships it may bring to Jane, one thing is certain – she will not be able to file a joint return for the calendar year after his loss.  Unfortunately, the ramifications of Jane now filing her taxes as a Single taxpayer are not great – thus the Widow’s Tax Penalty.   Let’s look at the numbers…

As the spouse of John, Jane would begin to receive John’s Social Security Benefit of $52,000, but would lose her own benefit of $26,000.

As the beneficiary of John’s IRA, and because they were the same age, Jane’s RMD would equal the total of both of theirs at $64,429.

Jane’s Gross income then would total $116,429 or $26,000 less than theirs together, but with half the standard deduction her taxable income would be $92,080 – nearly $3,500 more than the Married Filing Jointly situation – putting her top marginal tax rate as an individual filer at 22% for a total tax bill of $15,311 nearly doubling the effective rate of Gross Income to 13.15%.

So… in this widow’s situation Jane took in $26,000 less of income but paid an extra $5,138 dollars in taxes for a total Widow’s Penalty of more than $31,000!

The unfortunate part of this scenario for John & Jane is that having reached RMD age it will be harder to get as opportunistic in managing this situation, but for those of you who are in your 50’s, 60’s or early 70’s looking to keep the cost of taxation down over the remainder of yours and your spouse’s lives – planning is the key.

The simplest solve to the Widow’s Tax Penalty is to plan out Roth Conversions in years when it is advantageous to do so.  Two notes on this… 1. Some folks may have created such good income for themselves even into retirement – with pensions, rental income, non-qualified investment income, etc. – that there is no real advantageous calendar year to make this shift (although with the unknowns of future tax law it is still worth the examination) and 2. While I called the solution of a Roth Conversion “simple” it may not be “easy” as it will require paying more taxes NOW for the avoidance of taxes later.  

In the right situation a Roth Conversion helps in two significant ways.  First, planned correctly you can manage the conversion in a year where you are paying a rate of tax that may be lower than what you’d anticipate paying later.  In other words, you are removing a future high tax liability at a time when you can pay a lesser tax liability.  One easy example here is the potential for the expiration of the 2017 Tax Cuts and Jobs Act scheduled to occur at the end of 2025.  With no governmental intervention, you can see in this graphic that the 12% bracket will revert to 15%, 22% to 25%, 24% to 28% and so on.  Notably, the sunset would have you reaching some of the higher brackets at lower income levels as well.

The second way that a Roth Conversion can help combat the Widow’s Tax Penalty is by way of shifting wealth from your Traditional IRAs over to Roth IRAs.  This helps lower your future taxes by reducing the Required Minimum Distribution that must come out of the Traditional IRAs at age 73 and will be taxed at your highest marginal bracket.  Because so many people don’t NEED all or any of the RMD to meet their financial obligations or goals, the taxation of these dollars is particularly painful.  

When considering this sort of scenario, I can ‘t help but think back to the old Morgan Stanley advertisement which stated that “You must pay taxes, but there’s no law that says you gotta leave a tip.”  

Admittedly it’s a little weird to talk taxes around the loss of a spouse, I wouldn’t recommend it be an ice breaker conversation at your next holiday party.  But whether your wealth has been inherited or you’ve built it from scratch, I’d guess you’re like me in that you’d prefer that the use of your wealth – even after you are gone – would be directed more towards the people or causes you love than sent to Washington in the form of taxes.

If the idea of the Widow / Widower’s Tax Penalty raises questions about your own financial plan or tax strategy, or you simply don’t have a plan or strategy to speak of and would like to develop one reach out to our team of Certified Financial Planners at Professional Planning & Wealth for a complimentary review and conversation on how to get started.