Becoming a widow or widower means many changes for the surviving spouse, and that includes financial changes. Planning ahead for changes in income and taxes can lighten the impact.
The phrase “death and taxes” is commonly heard, but not often applied to what happens with the loss of a spouse. The surviving spouse is often faced with a double-whammy, according to a recent article in Kiplinger, “How Losing a Spouse Could Boost a Survivor's Taxes.” If there was a pension, the surviving spouse may lose pension plan benefits, and Social Security income will be cut to one payment instead of two.
It’s the income tax that really makes a big change for the surviving spouse. He or she will move from married filing jointly to single status. The standard deduction and exemptions will be reduced by half, resulting in more of the income being taxable and at higher rates. In addition, the money that's in a couple's tax-deferred saving accounts (401(k), 403(b), traditional IRA, etc.) will be 100% taxable when it's withdrawn. Therefore, the surviving spouse likely will be adding even more to his or her tax burden.
Here’s an example of a hypothetical couple: Geoff and Cindy. The couple has a combined $30,000 from Social Security and another $30,000 from an IRA. Because they're married filing jointly, only 23% of their Social Security is subject to income tax. As a result, they have $60,000 in income, but only $36,850 is subject to federal taxes. Their standard deduction and personal exemptions take care of about $23,200, which means they have a taxable income of $13,650. That puts them in the 10% tax bracket, and they pay $1,365 in federal taxes.
Geoff passes away unexpectedly, and Cindy is left on her own. While some expenses may change, property taxes, home and auto insurance and utilities will be about the same. Cindy will get the higher of the couple's two Social Security payments, but it's only $20,000 per year. Thus, to keep the same lifestyle she had when her husband was alive, she'll take more out of her IRA—$40,000. But now 85% of her Social Security will be subject to income tax. That’s because the amount she'll pay is based on a single filer. Cindy will have $57,000 of taxable income but just one exemption and half the standard deduction. Her taxable income will be $45,100. That puts her in a 25% tax bracket. She'll pay $7,046 in federal taxes. That’s quite a difference. In fact, it’s a 416% increase!
In the year of Geoff’s death, Cindy can still file as married filing jointly. This will let her make some important changes. Geoff’s life insurance proceeds can be used to pay taxes that will be incurred when converting a traditional IRA to a new Roth IRA. She would do this, so that she won’t have to pay taxes on the distribution she takes. There will be some requirements, but this will at least give her more control over her tax rates. This is another reason why life insurance is so important for the surviving spouse. That tax-free death benefit gives them more options, in both the short and long term.
Reference: Kiplinger (October 13, 2017) “How Losing a Spouse Could Boost a Survivor's Taxes”