Hey guys, Mike Frontera here, back with another Retirement Theory video.
When planning out a couple’s retirement, it’s generally accepted that income will go down at least somewhat when the first spouse passes away. Beyond the obvious grief a surviving spouse deals with, there’s the financial aspect of having less income to cover expenses. This is usually from the loss or reduction in a pension, the loss of a part-time job perhaps, and of course the loss of one Social Security benefit.
What very often catches them by surprise though is that their tax bill often doesn’t reduce with that lowered income. In fact, many times it goes up. Sometimes way up.
You may see around the Internet the phrase “the widow’s tax” or “the widow’s penalty”. So today, I’ll go over what that is, how it happens, and more importantly, what you can do ahead of time to plan for it.
Alright, first, let's talk about why the tax bill actually jumps.
To do that, let’s review how you’re taxed. Basically, you pay taxes on what’s called your taxable income. And the tax rate you pay on that income changes, depending on how big that taxable number is.
So how do you determine your tax rate? Your rate is based on where your income falls throughout these tax brackets. So, tax brackets are progressive. That means your income doesn't get taxed all at one single rate. (go through example)
Before any of that gets applied, though, you get to take deductions off your gross income to arrive at that taxable income figure. The biggest one of those deductions, which has really grown monstrously large in the last few years, is the standard deduction.
For a married couple filing jointly, that's a healthy chunk of income that comes off tax-free before the brackets even come into play. [GRAPHIC: MFJ standard deduction] And if you're 65 or older, you get an extra bump on top of that, for each spouse who qualifies.
And right now there's an additional senior bonus deduction on top of all of that. Up to $6,000 for a single filer, or $12,000 for a married couple where both spouses are 65 or older. All said and done, a couple with both spouses age 65 or older, can take $47,500 off, just with the standard deduction, before arriving at their taxable income.
By the way, this extra $12,000 bonus is currently scheduled to run through 2028, and it does phase out at higher income levels.
So, put that all together for a married couple. You take that ultimate taxable income and you parse it along these tax brackets to determine what you owe the IRS. And in a minute or so, I’ll walk you through an example of it.
So where does the widow’s tax come in? Well, let’s see what happens when one spouse passes away.
In the year after the first spouse dies, the surviving spouse has to file as a single filer. That’s generally speaking. Technically, there is a two year special status called “Qualifying Surviving Spouse”, but to qualify, you need to have a dependent child living at home and you paying more than half of your home’s upkeep costs. But, and especially with retirees, that’s not a common situation and we’re not gonna get into that today.
So what happens as a single filer… well, lots of bad stuff.
First, you get to deduct a lot less to arrive at your taxable income. For a married filing jointly status with both of you age 65 plus, remember that your standard deduction was $47,500. As a single filer age 65 plus, that goes down to…$24,150. So if your taxable income was the same as when you were married, you’re getting taxed on an extra $23,350 of it.
Worse than that, your tax brackets themselves are greatly compressed. Meaning that taxable income reaches a higher rate of taxation faster as a single filer versus a married filing jointly status. Look at the difference, especially here between the 12% and 22% rate how much less income it takes before your tax rate is almost double.
Now you may be thinking – but my income won’t be the same, it will be lower because one of our Social Security payments will be gone. Yes, that is true. Typically, once the first spouse passes away, the lower of the two benefit amounts will stop and the higher amount will come in as a survivor benefit.
But now let's talk about Social Security. Because I didn’t really address it when discussing income taxes on your retirement income. Social Security is taxed in a funny way. Not funny “ha ha”, more funny like “that’s weird and confusing”.
Whether, and how much, of your Social Security is taxable depends on something called provisional income. I went through how provisional income is calculated in-depth in a past video that I’ll link in the description. But the key point is that even with lower overall benefits, you may end up having to pay more tax on those benefits as a single filer because of the way provisional income is calculated. I’ll talk about this in my example.
And the hits keep coming. Medicare premiums for Part B and Part D use income-based surcharges called IRMAA. [GRAPHIC: IRMAA] And just like the tax thresholds, those brackets are also based on filing status, with the brackets for each higher surcharge coming with far less income for a single filer than for married filing jointly.
So a surviving spouse may end up paying more for Medicare too -- even after their income has come down.
Oh, and what about state income taxes? Forgetting the brackets themselves, many states provide for exclusions or tax breaks on retirement income like IRAs for each tax payer. For example, in NY each taxpayer can take the first $20,000 of IRA withdrawals without NY tax under the pension and annuity exclusion. For a couple that each has IRA money, that’s $40,000 total excluded from NY tax. For a surviving spouse, it’s just the $20,000. We have clients in states like Georgia, South Carolina, Kentucky, and others that have similar “per taxpayer” breaks on retirement income.
Of course, your retirement account balance doesn’t suddenly get smaller when you become a surviving spouse. Your Required minimum distributions typically keep coming out on a similar schedule, regardless of filing status. So that income, which used to get taxed at joint rates, now gets taxed at single rates, pushes your Social Security to be taxable income faster, and may also have less in the way of state income tax breaks too.
Alright, we’ve got a lot of variables up in the air here. Let's put some real numbers to this, with our friends Jerry and Ginny.
[HOLISTIPLAN GRAPHIC: Jerry and Ginny's baseline MFJ scenario] ---. Run through LOOM
Here's Jerry and Ginny filing jointly. Take a look at their income sources, their taxable income, and their tax bill for the year.
Jerry’s SS is $3000 per month, o4 $36,000 per year
Ginny’s SS is $2500 per month, or $30,000 per year
On top of that, they’re drawing out $90,000 per year from their IRAs
In total they have $156,000 of gross income
Now let's say Jerry passes away. The following year, Ginny is filing as a single taxpayer.
She still has the total benefit of $3000 per month that Jerry was receiving, and she is still drawing $90,000 per year from her IRA, which now contains her and Jerry’s IRA funds.
So her total income is reduced by her own SS benefit, which was $30,000 for the year. So instead of $156,000, Ginny now lives on $126,000.
[HOLISTIPLAN LOOM: WALK THROUGH SIDE-BY-SIDE OF ARRIVING AT AGI AND TAXABLE INCOME]
And here's that Medicare piece I mentioned earlier. Watch what happens to her premium tier, even though her income actually went down from when Jerry was alive.
So what can you actually do about this?
There’s a couple big things you can do.
In the year your spouse passes away, you can still file a joint tax return. [GRAPHIC: “Year of Death = Still MFJ”] That's an important year because it’s the last year you get to use those wider joint tax brackets and the full joint standard deduction.
So, if you can, make that year count. Consider it a year to accelerate income, take larger IRA withdrawals, complete a Roth conversion, all you're still getting joint tax treatment.
Of course, you have to have enough time in the year to do something. If your spouse happens to pass away in mid-December, your first thoughts are probably not rushing around to do some tax planning.
Second, more broadly, strategic, tax-efficient IRA distributions and Roth conversions while both spouses are alive. Filling up those lower joint brackets now can shrink the taxable required withdrawals the survivor would otherwise be stuck with later, at single rates. You can take that time to build a pool of tax-free Roth assets, or even a pool of taxable investments that may be eligible for a step up in basis once the first spouse passes away.
Third, consider delaying Social Security, especially for the higher earning spouse. This does two things. It locks in a larger permanent benefit for whichever spouse survives. Social Security is solid income that is not adjusts for inflation, it’s also tax-efficient. As I mentioned before and in previous videos, the portion of your Social Security benefits that are subject to taxation can be as low as 0% and at a worst case only 85% are taxable. So at least 15% of that income stays tax-free no matter what. And most states don’t tax it at all! Sorry Colorado, Connecticut, Minnesota, Montana, New Mexico, Rhode Island, Utah, and Vermont.
The other thing delaying does is buy you more years to do Roth conversions before Social Security is even in the picture, since once those benefits start, conversions start pushing more of that Social Security into taxable territory.
The point of all this is that tax planning is super important. And not just for the current year. Unfortunately, you can’t plan retirement taxes as if you're always going to be a couple. At some point, one of you is going to be filing that return alone. And the steps you take as a couple now, can provide better financial security for whomever is left as a survivor.
So, do you have questions for me? Let me know. Come visit me at www.retirementtheory.com or send me an email at mike@retirementtheory.com. Once again, thanks for joining me. We'll see you next time.