How the widow’s penalty tax hurts your retirement security
I recently attended a celebration of the life of a good friend who passed away. It got me thinking about widow’s grief and what it means for the surviving spouse, beyond the nightmare of losing a spouse and mate, of course.
It is common for spouses to leave their savings to each other. Yes, there are more advanced estate planning techniques that can split the money between widow / widower, children, foundations, charities, etc. Yet these strategies are mainly used by the very wealthy trying to avoid being affected by estate tax. Even in these cases, the surviving spouse usually has enough money / income to live a comfortable retirement.
Beyond the loss of company upon the death of a spouse, there can also be financial and tax consequences. This is often described as the widow’s punishment. Sorry guys, at least stereotypically guys die first. As a fan of Golden girls, it was a show about three widows and a divorcee who often wished her ex-husband was dead.
For clarity, I will use the term widow for the surviving spouse. But the situation here is the same if we are talking about a widower. Likewise, nothing changes if we are talking about gay married couples or lesbian married couples in which one spouse has died.
You are probably wondering what is the widow’s sentence? If she inherits all of the household assets, that should be fine, right? In some cases, surviving spouses may end up with more assets or even a higher base cost in assets they already owned (i.e., receiving the proceeds from life insurance) . In addition, if they own the family home, they will receive a cost increase on half of the deceased’s home. Likewise, the widow can benefit from a base mark-up on highly valued stocks and bonds. These things could make the home and investments more valuable if they have to be sold.
Other sources of income may disappear, for example social security. The household would go from two checks to one. Fortunately, the surviving spouse can continue to receive the larger of the two Social Security benefits. Also, if there is pension or annuity income based on a single lifetime, that income will likely disappear.
Example of a widow’s penalty in action
Consider my clients Jim and George. They had a dream retirement with a combined income of over $ 350,000 per year and several homes. Life was good. Then George fell ill and died. Jim inherited all of George’s assets. They both had substantial incomes throughout their careers, but George’s death meant Jim would lose over $ 42,000 a year in Social Security benefits. Adjustments could and should be made to compensate for this loss of social security benefits.
The widow’s nut penalty kick came later when Jim first filed taxes as the sole filer. Suddenly, he was going to have to pay more taxes on a lower income. The problem was magnified because Jim is a resident of a high tax state, California. Its federal income tax rate has increased, as has its state income tax bracket.
Jim and George funded their retirement income with a combination of taxable withdrawals from a traditional IRA, non-taxable Roth IRA distributions, two Social Security benefits, and income from investment accounts taxed as capital gains. Some of their taxable income has been pushed into higher tax brackets, and more of their income has fallen into their current highest tax bracket at the federal and state levels. They also saw a large Obamacare surcharge of 3.8% on investment income when filing as a single person. Now Jim will have a smaller standard deduction as a widower than when George was alive.
The good news is, they’ve planned a financially secure retirement. Jim will get by and adjust his expenses to reflect his new high bills and reduced income. Many retirees will not have this luxury. Some expenses will disappear or become cheaper with the death of a spouse, things like cell phone plans, medical insurance and care, and even car payments. Other expenses are the same regardless of the number of people in your household, such as cable, mortgage, property taxes and, for the most part, utilities.
While Jim and George spent decades investing to fund a retirement income they wouldn’t survive, they never thought about the widow’s penalty until they started working with me as a financial planner. The widow’s penalty is problematic now, but could increase if tax rates increase in the future. While I don’t claim to know exactly what the tax brackets will look like 20 years from now, I would be surprised if they weren’t considerably higher than they are today. Fortunately for Jim (and George), they had income with diversified taxation (taxable, pre-tax, Social Security (which has favorable taxation), and capital gains), which partially alleviated the widow’s sentence for Jim. If their income came 100% from taxable accounts, the widow’s penalty would have been much more painful.
The widow’s sentence: beyond taxes
There is another way widows are often penalized when their spouse goes through – MEDICAL BILLS. When your spouse is sick or needs Long term care, you are probably not thinking about your monthly budget. End-of-life care can undermine retirement savings and can even leave the surviving spouse with a pile of medical debt or depleted savings due to long-term care costs. Few households have enough money to pay for long-term care for a spouse, let alone two. In scenarios like this, the widow’s penalty can be severe, a loss of income sources, a small nest egg to generate retirement income, and higher taxes on the remaining income.
Qualified widow exemption
There is a small exemption to avoid the widow’s penalty for two to three years. This exemption only applies if you have a dependent child living with you. So, I’m going to say this won’t apply to most retirees, although there is an exception. As a gay financial planner, I work with many gay couples who have children later in life. In some cases, they retire, but their children have not yet left the house.
A qualified widow or widower is a specific tax status that allows the surviving spouse to use the joint declaration of spouse tax status for up to two years after the death of the spouse. This is in addition to the year of death, during which the surviving spouse can potentially still use the status of jointly filing spouse.
If you find yourself widowed or widowed, do yourself a favor and be proactive about any financial changes that may be required, such as adjustments to your taxes and changes to your retirement income withdrawal strategies. Likewise, don’t forget to update your beneficiaries and update your life insurance and long-term care coverages.