While this book is focused on what to do when you inherit an IRA from a spouse, we would be remiss if we ignored the Widow’s Penalty.
From a strategic point of view, you will want to understand this IRS concept as it can have a material impact on your finances going forward. Because of its importance, we have gone into somewhat greater depth on this subject.
Bear with me; it’s crucial.
The Widow’s Penalty: What It Is and How to Tame It
Remember Lisa? Let’s imagine Lisa’s situation two years after Peter’s death. Year one was a fog, but year two has been a real wake-up call as she navigates the end of one major reprieve that she didn’t even know she would get from the IRS.
From now on, unless she remarries, Lisa will go from the tax advantages she and Pete had enjoyed to the tax burdens of being single. It’s part of what is called the “Widow’s Penalty.”
We know that grieving is an unpredictable process, moving at a different speed for each of us. Both ups and downs seem to come out of nowhere and take on a life of their own. Many widows speak of the second year as being worse than the first.
Reality becomes harder to ignore in the period before a newfound purpose has had the chance to take hold. The second-year is also when widows and widowers alike find themselves grappling with this new financial issue. What exactly is the Widow’s Penalty?
Marriage Brings a Double Whammy
The IRS seems to have marriage in its crosshairs. Many of us remember that, as newlyweds, we were penalized when we first filed “married jointly.” With our new partners, we paid more income tax than two single individuals would on the same total income. It was referred to as the “Marriage Penalty.”
Now, when we lose a spouse, instead of recapturing those lost benefits when we go back to filing “single” again, the federal income tax code is stacked against us. Now the tax rates for married couples filing jointly can be far less onerous than for single people. This is called the “Widow’s Penalty.” This disadvantage is an equal-opportunity offender: it affects both widows and widowers alike, as well as people at various income levels.
How the Widow’s Penalty Affects Taxes
Retirees typically live on their various sources of fixed income: Social Security benefits, pensions, and distributions from qualified retirement plans. (These may be in the form of Required Minimum Distributions, or RMDs.) As a widow, you will presumably continue receiving the same investment and property rental income, for example, so the main impact on your gross income will be the loss of the smaller Social Security check if you had been receiving two.
The reduction in taxable income from losing the Social Security check will likely be partially or fully offset when the joint standard deduction you are accustomed to taking is replaced by the smaller single standard deduction. In 2020, your deduction will go from $24,800 to $12,400.
Plus, an additional $1,650 if over age 65 or blind
Your taxable income may end up higher than before, but even if it is the same, your taxable income as a widow will now be taxed at the rates on the tax tables for singles, where next tax-bracket thresholds occur at much lower dollar values.
For example, for 2020 income, $41,000 of taxable income will be in the bottom third of the 12% tax bracket for married filing jointly, but already in the 22% bracket for singles. A taxable income of $170,000 will be at the very top of the 22% tax bracket for married filing jointly but already into the 32% tax bracket for singles.
The only momentary reprieve a widow has is in the year in which a spouse dies: the widow or widower can still file a tax return using the more generous “married filing jointly” tax status.
Social Security’s Tax Torpedo
What part of your Social Security benefits gets taxed depends on an IRS formula called “combined income.” Somewhere between 0% and 85% of your benefits could be counted as taxable income. Here again, an IRS rule affects a widow negatively.
In 2020, if you are married filing jointly, and your joint income is over $44,000, 85% of your Social Security will be taxable. Between $32,000 and $44,000, 50% is taxable. Below $32,000, none is taxed. However, when you are filing single, and your income is over just $34,000, 85% of your Social Security will be taxable. Between $25,000 and $34,000, 50% is taxable. Below $25,000, none is.
Therefore, even if your Social Security benefits are reduced by losing the smaller of the two checks you were receiving, changing from joint to single status can bump you up from one taxable income range to another and cause more of your Social Security to be taxable. This is referred to as being hit by the Social Security “Tax Torpedo.”
The RMD Hit
Starting at age 72, the loss of a spouse does not lessen your requirement to take minimum distributions each year from all IRAs (including those you inherited). Because withdrawals are now mandatory, you lose the flexibility of being able to withdraw less in an attempt to lower your tax burden.
Your life expectancy determines how much you must withdraw. The fewer years of life expectancy left, the higher the percentage of the account’s year-end value you must withdraw. For age 75, it is 4.37%, and for age 80, 5.59%. So, while the balance in your accounts may be going down due to forced withdrawals, the percentage is going up.
Surtax on Net Investment Income
The 3.8% surtax on net investment income—a provision of the Affordable Care Act, or Obamacare, to fund Medicare—is another wrinkle. Married couples are only affected at Modified Adjusted Gross Income, or MAGI, amounts over $250,000. For single filers, it is over $200,000, so the widow’s $210,000 MAGI can trigger the surtax, whereas the couple’s $245,000 did not.
Medicare Piles On
Widows are not only affected regarding their taxes but regarding Medicare premiums, too. Income levels determine monthly Medicare Part B (medical insurance) and Medicare Part D (prescription drug coverage) premiums. The rule is called Medicare’s Income-Related Monthly Adjust Amounts (IRMAA).
In 2020, if you and your husband had a MAGI of $174,000, your Part B premium would have been the $144.60 standard monthly premium, or $289.20 for the two of you. At a similar MAGI ($174,000), as a single individual, your Part B premium in 2020 will be the $144.60 standard premium + $318.10 extra, or $462.70 for you alone.
The Part D monthly premium for each of you would have been simply the cost of your selected plan. Now the premium will be the cost of your selected plan + $70.00. The chart on the next page represents the IRMAA threshold of 2020. Each year, surcharges will be adjusted for inflation.
IRMAA surcharges apply on a “cliff” basis. Reaching the first dollar of an IRMAA income level causes the full corresponding surcharge to apply to all premiums paid for the year. In simpler terms, go over the “cliff,” and you pay more.
Widows and widowers are equally disadvantaged by IRS and other legislation. With that in mind, if you are still married, it is essential that you run tax projections, both under the “married filing jointly” and “filing single” scenarios, projecting out 10-15-20 years.
This planning is effective when done while both spouses are alive and preferably before the primary breadwinner has retired. The earlier, the better, in terms of having more options and more time to implement them. The three major areas to explore are (1) Roth IRA conversion strategies, (2) Social Security claiming strategies, and (3) reverse mortgages.
Roth IRA Conversion Strategies
Any taxpayer can convert an IRA to a Roth IRA. However, the conversion comes with a cost in the form of taxes. For example, Krista converts her $50,000 traditional IRA into a Roth IRA. Krista will add an extra $50,000 of ordinary income on which she will pay taxes.
Tactically, the conversion is easy. It is synonymous with waving a magic wand over your IRA, which is infested with tax liabilities, and turning it into a Roth IRA. After conversion, those funds will then enjoy tax-free withdrawal status. It is also important to note, RMDs are not required from a Roth. Therefore, future exposure to taxable RMDs is eliminated.
Also, while this will provide greater withdrawal flexibility on the part of the owner, it will be even more valuable for the surviving spouse to control the impact of the Widow’s Penalty. By planning well in advance, conversion can take place in a series of small transactions over the age 60-to-72 timeframe, scheduling them to take advantage of the lowest tax brackets (if possible).
For example, a series of smaller partial Roth IRA conversions may work wonders. A concept of “bracket bumping” or “filling out the bracket” works as a guideline to determine how much should be converted each year. With this strategy, you consider your income level and what tax bracket you’re in. If it makes sense, you convert enough of your IRA to use up the remainder of the tax rate bracket you’re in without exceeding it.
Here’s an example.
Let’s say you’re single. Your total income for the year 2020 will be $17,500. When we go to the tax table, we see that you’re in the 12% bracket. (For 2020, this bracket goes up to $40,125 for single filers; above this, you move into the 22% tax bracket.)
You could convert up to $22,625 of traditional IRAs to a Roth IRA to “fill out” the bracket without “bumping” yourself up above the 12% rate.
By using this strategy, you have a very good understanding of what the conversion will cost you in tax dollars.
Social Security Claiming Strategies
Couples may be anxious to start receiving Social Security benefits.
However, the longer they wait, the higher the benefits will be—with the largest payout coming by waiting to age 70. Not only will benefits increase each year you wait, but the compounding effect on Cost-of-Living Adjustments (COLAs) is very beneficial.
Waiting as long as possible before claiming Social Security benefits for the highest earner within a couple will give the surviving spouse the highest lifelong income since that is the benefit that will survive.
If all other income is meticulously timed, the taxable portion of the Social Security benefits may also be held down into one of the lower brackets (0% versus 50% versus 85%) for relief from the Widow’s Penalty. Deferring Social Security claims may require supplementing available funds.
Two options come to mind for funding living expenses temporarily at an advantageous tax rate: the careful withdrawal from traditional IRAs after age 59½ or divesting of other investments. Other funding mechanisms like a reverse mortgage line of credit or life insurance policy loan should also be explored.
The key is to examine all possibilities in terms of timing, total payouts, flexibility, and tax implications when determining Social Security claiming strategies.
The above article originally appeared as a chapter in Inheriting Your Spouse’s IRA and is reprinted with permission from the author Bill Harris, RMA®, CFP®. No parts of this article may be reproduced without correct attribution to the author of this book.
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