Widow’s Penalty: Tax Increase after Loss of a Spouse
What is the widow’s penalty?
What happens at the death of the first spouse? After the emotions, there are also tax and financial implications: The Widow’s Penalty. Also known as Widow’s Tax Penalty, taxes increase for most when they become widowed.
Tax implications of filling taxes as single instead of married filing joint often leave the surviving spouse worse off financially.
In addition to a loss of social security income, what income remains hits higher tax brackets. Therefore, the Widow’s tax is an important consideration when retirement planning for a couple.
After all, one spouse will be left behind. What happens then?
Do Widows Pay More in Taxes Once a Spouse Dies?
Yes, in general, widows pay more taxes once their spouse dies. This is due to the standard deduction being cut in half when you file as a single compared to married filing joint due to the compression in tax brackets.
For instance, the top of the 12% tax bracket is $41,775 when you are single and twice that ($83,550) when you are married filing jointly. This means you will pay an extra 10% for the next $41,775 the year after you suffer the loss of a spouse.
What are the Implications of the Widow’s Penalty?
What are the implications of the Widow’s Tax?
- Decrease in Social Security and Possible Increase in Taxation of Social Security
- Decrease Standard Deduction
- Increase in Marginal and Effective Tax Brackets
- Increase in IRMAA
- RMDs often stay the same (with compressed tax rates)
- Possible loss in Pension Income
Next, let’s look at an example. Here, we have a 70-year-old couple. What happens to taxes after the first spouse dies at age 73?
Widow’s Penalty and Net Worth, Taxes
Let’s look at a scenario to see how the widow’s tax penalty works. Here, we have a 70-year-old couple, and a spouse either dies at 73 or does not. How does that affect net worth and taxes over time?
On the top of figure 1, you can see that this couple is 70 and have a $1M net worth. In dark green, you can see a slow decrease in net worth over time with a spousal death at age 73, vs. no spousal death in light green.
Why is there a decrease in net worth? One reason is increased taxes on the widow. The Widow’s Tax!
On the bottom of figure 1, you can see how much is spent yearly in taxes. At baseline in green, the couple owe about $6,000 in taxes and this slowly increases over 30 years to $15,000.
In blue, a spouse dies at age 73, immediately increasing taxes up to $10,000 a year. The widow continues to pay increased taxes over the remaining 30 years.
Next, let’s look and see what spousal death does to the tax rate.
Increased Taxation of the Surviving Spouse. The Widow’s Penalty
In figure 2, 2022 on the left: the year before death. Below are two possibilities: 2023 without and with 2023 Death of a spouse. Now we can see how the death affects the following years’ taxes.
Note that income decreases by 50% after death (due to loss of a social security check).
Taxes, however, also increase by more than $3k! What! Less income yet more taxes!
Net outflow increases to cover both increased taxes and loss of social security.
Note next social security benefits received, the amount that is taxable on their 1040s, and the percent of social security that is included in their taxable income. Due to the spouse’s death, the full 85% of social security is included after death of the spouse, when it is only 72% taxable (and double the amount) without death.
Also included are AGI and the standard deduction. I invented a ratio: the standard deduction to AGI ratio. The higher the better, because that means you have a significant standard deduction compared to your adjusted gross income. Note the increase in taxable income due to the cut in half of the standard deduction.
Do Widows get a Tax Break?
No, widows do not get a tax break. If your spouse died this year, you can still claim as married filing joint. If the widow has dependents, there is a qualifying widow filing. The point of the widow’s tax is that widows get the opposite of a tax break!
An Academic Perspective of the Widow’s Tax Penalty
I thought it interesting this summer an academic-ish paper was published calling the Widow’s Tax “fearmongering.”
The title: Widow tax hit: much ado about nothing? The purported purpose of the paper is to prevent “fear appeals used by financial planners to motivate client behavior.”
The author suggests we relax and let go of the fear. I’m not sure that fear is what we are after, just understanding the tax implications after the death of a spouse!
He further suggests that the impact of higher taxes and loss of disposable income is “minor.”
While truly not massive, the paper shows the jump in effective tax rate is 30-55% for a wealthy couple and 12-15% for a median couple. That’s pretty impressive to me and perhaps not what I would consider minor.
In addition, the reduction of disposable income is 12-20%.
He states only when the tax torpedo is invoked can there be problems, and bags on people pitching Roth conversions and life insurance as a way to prevent widow’s tax.
Maybe he is just bashing life insurance. Life insurance is not taxable but widow’s tax might be an inappropriate scare tactic.
But I think he misses the point. If you can do some simple planning and not suffer an increase in taxes and a 20% reduction in disposable income, is that worth it? Is that fearmongering?
Who is going to pay the taxes? IRA Legacy Planning
Next, let’s look quickly at IRA Legacy Planning. After all, you need to decide what to do with pre-tax retirement accounts due to becoming a widow.
IRAs are tax timebombs, and someone will pay the taxes. Who? You, Your Spouse, or Your Kids? Someone will pay the taxes.
Do you and your spouse want to pay the taxes, or leave them for the kids to pay? What about if one of you dies prematurely? Should you optimize your IRA for life as a widow?
What about if your goal is to leave money to charity?
IRA Legacy Planning is an important once you have determined you have enough to safely retire. After all, it is no fun paying more than you have to in taxes, so why not optimize your IRA?
IRA Legacy Planning and Goals
What are some common goals for the IRA?
If there is enough to go around, then optimization includes considering leaving money to your children and/or to charity. Qualified disclaimer Estate Planning is important (and easy!) to consider first.
Let’s look at the goals of your IRA when we consider IRA Legacy Planning.
Charitable Intent and IRA Legacy Planning
If you have charity as your legacy goal, planning becomes fun and easy! Spend what you want and leave the rest to charity.
Or, with some IRA Legacy Planning, pay less in taxes during your lifetime to leave more to charity.
Once you have a future tax projection in place, see what your Required Minimum Distributions will be in the future. Now, mitigate your RMDs and keep you in an optimal tax bracket during your lifetime via Tax Bracket Arbitrage.
Instead of recognizing your RMDs as income, once you are 70 ½ (the SECURE Act didn’t change the age you can start QCDs), you can give your pre-tax money directly to a qualified charity. If you do, you don’t need to recognize this money as income. This can keep you in a lower tax bracket, in addition to many positive downstream effects like decreasing taxation of social security, reducing IRMAA surcharges, keeping tax credits that would otherwise phase-out, etc.
Partial Roth Conversions –
If you are going to be in a much higher tax rate in the future, but your plan calls for some extra tax-free income later in life, consider partial Roth conversions. However, remember your “heir’s” income tax bracket is ZERO (charities don’t pay tax on pre-tax money!) so be careful not to overdo Roth conversions.
Charitable Remainder Trusts –
CRTs are an important tool! If you are giving your nest egg away to a large institution, they retain estate lawyers who would be happy to help you set up a Gift Annuity or Charitable Remainder Trust. These can be effective ways to generate (taxable) income during your life, while getting a present-day tax deduction based upon your future expected gift.
Basis in Brokerage Account –
Remember that charities also don’t pay capital gains taxes, so gift them equities with high basis (significant embedded capital gains) while living or in your Will.
Giving your nest egg to charity is fun but hard work if you want to optimize your nest egg. So let’s move on to a more difficult discussion: nest egg optimization for couple or a single spouse.
IRA Legacy Planning for Couples
Who is going to pay the taxes? A couple or a widow? There can be massive tax implications.
Let’s consider a couple for the time being. They don’t have significant goals to give money to their children or charities, but want to have a comfortable retirement.
Here, it makes sense to optimize taxes for three different scenarios: Both have long lives, or one or the other passes on early in retirement.
IRA Legacy Planning for the Children
If you want to leave the most possible behind for your children, consider permanent life insurance for the death benefit. Not infrequently, this would be a second to die guaranteed universal life insurance policy with no cash value.
If you want to stay away from life insurance, consider partial Roth conversions. Of course, here, you need to be concerned with what your children’s future tax rate will be. Due to the death of the stretch IRA via the SECURE Act, no longer can they stretch out their inherited IRAs, so consideration for Roth conversions becomes even more critical. Review this important concept in the 10-year rule and your Retirement Accounts.
You don’t want to convert at a high tax bracket for a low-income heir, however. Why pay taxes now when they can pay fewer taxes in the future?
If you have high income and low-income children, consider leaving your pre-tax account to the low-income children and your Roth and brokerage accounts to high income children.
Leaving Money to your Heirs is a complicated topic that will take some IRA Legacy Planning.
Pre-Tax Accounts and IRA Legacy Planning
Much of the consideration for IRA Legacy Planning comes from the pre-tax account. As this money will always be taxable unless left to charity, it is most important to consider what to do with your IRAs and 401k/403b plans.
In addition, Required Minimum Distributions force this money out. Initially, there are only small minimums, but over time, these distributions can force you up into the very highest tax brackets if you have large pre-tax accounts.
You want to spend down or convert you pre-tax money if the accounts are large, or if there is a chance you will be a single spouse subject to higher tax brackets. In addition, if your heir will be in a higher tax bracket than you are currently in, Roth conversions make sense.
On the other hand, you might consider deferring spending from these accounts if your heir is in a low tax bracket or if you have charitable intent. If nothing else, consider de-bulking your IRA via Partial Roth Conversions.
So, who will pay the taxes?
Who Will Pay the Taxes? IRA Legacy Planning and Widow’s Penalty
First off, understand that this question is only intended for those with plenty of money left. If you can comfortably spend from your nest egg and will have leftovers, then you can worry about the taxation.
But understand this: Taxes will be paid. Doesn’t it make sense to think about the lifetime taxation of both you and your spouse, AND your future heirs? This is IRA Legacy Planning, and it stacks nicely with a discussion of the widow’s tax.
So, when you plan for death and who will pay the taxes, need to decide who to focus on. Your goals and priorities determine who will pay the taxes now and in the future.
Conclusion: Widow’s Penalty
Due to the Widow’s Penalty, also known as the Widow’s Tax Penalty, there is an increase in taxation of social security and a decrease in the tax brackets. This leads to an actual reduction in net worth over time as more income is needed from the fully taxable IRA to pay taxes and expenses.
In addition, there is a loss of a social security check with the Widow’s Tax. In this scenario, social security met 43% of income needs of the couple, whereas it only meets 26% of the needs of the remaining spouse.
While variable expenses do decrease after the death of a spouse, most of the fixed needs stay the same. Most singles will find they spend about 80% of what they did before the death of their spouse.
Aside from the emotions, there are financial implications with the death of a spouse.