Common tax surprises for surviving spouses

Survivorship income is one of the most critical aspects of retirement income planning, but for many, it is also an area that is over-simplified, or even overlooked in the planning process.

A common misconception is that a surviving spouse might only need 50% of the joint income required while both spouses are living. However, the surviving spouse typically needs more like 80% continuance of income to maintain their standard of living. This, coupled with reductions of various income sources, and adjusting to a higher income tax bracket as a single filer, requires extensive planning.

Some of the most basic reductions of income for surviving spouses include a reduction of Social Security income, and a reduction or even elimination of pension benefits. There are also many additional, more complicated reductions that survivors may need to contend with.

With Social Security benefits, if the widow or widower is full retirement age or older, the survivor’s benefit equals 100% of the deceased spouse’s worker’s benefit amount. However, the surviving spouse will either receive their benefit, or their late spouse’s benefit, whichever is higher — not both benefits. Pensions can also carry an income reduction for the surviving spouse, and it is important to understand the survivorship implications at the time that pension options are elected. These options range anywhere from 0% to 100% to the surviving spouse.

What often comes as a surprise is that survivors often also face tax disadvantages, known as the widow’s (or widower’s) penalty, when they lose their joint filing status. During the year where a spouse dies, the surviving spouse can typically use the joint filing status. For the two tax years following the year of a spouse’s death, the surviving spouse can file as a qualifying widow or widower. As the name implies, one must meet certain stipulations in order to qualify for this unique filing status, and those stipulations often eliminate those who are of retirement age.

To qualify, the surviving spouse would have to meet four requirements. First, in the year of your spouse’s death, you must be eligible to file as married filing jointly, even if you didn’t actually file as married filing jointly. The next requirement states that you cannot have remarried before the end of the tax year. Third, you must have a dependent child, stepchild, or adopted child. Foster children would not satisfy this requirement. Finally, you must have paid more than half the cost of maintaining the primary home of your dependent child for the entire year.

Under this status, you can use the married filing jointly tax table, as well as the same standard deduction as the married filing jointly status. However, you cannot claim an exemption for your deceased spouse.

Forced to use single filing status

Once a survivor is forced to use a single filing status, they are quickly faced with the possibilities of an increased tax bracket, increases in Medicare premiums, increases in Medicare surcharges, and increased Social Security taxation, just to name a few.

For the tax year of 2017, if you are filing as married filing jointly and your taxable income (line 43 of your 1040 tax return) is $50,000, you will owe $6,567 in taxes. At that same taxable income level for one filing single, you would owe $8,239. This is a $1,672 (or over 25%) increase in taxes owed. When you move to a single filing status, your standard deduction is cut in half. If you are 65 or older, or blind, both of which result in an additional $1,550 of deductions, you will be able to utilize those additional deductions whether you are married filing jointly or single filing status.

Social Security can be a taxable source of income for many, depending upon income, and that taxation threshold is much easier to reach if you’re not married. SS taxation for a married couple begins when the provisional income (Adjusted Gross Income, excluding Social Security, plus 50% of your SS benefits, plus tax-free interest from municipal bonds) is over $32,000, at which point 50% of your Social Security income becomes taxable. For those who are single, you reach that first threshold at only $25,000 of provisional income.

Married couples will reach the next tier of Social Security taxation (85%) at $44,000 for married couples, but only $34,000 for those who are single.

The net Social Security income one receives is also dictated by their Medicare Part B premiums, since Medicare Part B is deducted from Social Security income. Medicare Part B premiums easily increase when you must file with a single status. For example, a couple filing jointly currently doesn’t experience a Medicare premium increase to $187.50 until their joint income exceeds $170,000. When filing single status, that threshold drops to $85,001

Additionally, surcharges for Medicare (which is deducted from your Social Security income) are based off of your income for the last tax return that the IRS has on file. If your income drops due to the loss of your spouse, then you can file Form SSA-44, along with proper supporting documentation, with the Social Security Administration and request that the IRS consider this decrease in income in the determination of your surcharges.

All of this may leave you wondering what type of advanced planning can be done to alleviate the burden on the surviving spouse, and it’s important to consider options available while both spouses are living. There are two primary strategies that can assist the surviving spouse with reducing their taxable income.

Consider full or partial conversions to Roth IRAs

The first strategy to consider is full or partial conversions to Roth IRAs. Often, the majority of life savings accumulate inside of tax-deferred vehicles, such as Traditional IRAs and 401(k) plans. The challenge with this retirement savings strategy is that all income will be distributed from taxable sources.

Converting funds into a Roth IRA means that the IRA owner must pay taxes on the converted amount now, but will no longer pay taxes on distributions in the future (as long as the conversion is done properly, and IRS rules are followed pertaining to distributions). The concept behind converting funds to a Roth IRA is paying the taxes in a strategic, controlled manner, rather than deferring all taxes to the future. There are often strategies that can be utilized to slowly convert funds from Traditional to Roth funds, while maintaining the desired income tax bracket. This type of advanced tax planning should always be conducted with an expert, and with the assistance of a CPA.

The Roth allows an account owner to pay taxes now on the seed when the taxes are lower, rather than years down the road on the harvest when the taxes are higher. This strategy, when executed properly, can provide tax free income to both the account owner during their life, and their surviving spouse. This can be particularly beneficial in keeping a surviving spouse in a lower income tax bracket.

Consider life insurance

Life insurance is another tool for survivorship planning. Often, industry experts and individuals alike view life insurance as a way to pay off debts — mortgage and otherwise — and to cover funeral expenses. There’s a common misconception that there is no need for life insurance when debts are paid off, and there are sufficient funds for burial costs. However, since life insurance proceeds are typically income-tax free, they can provide a valuable resource for surviving spouses, who may have no other source of income that is income-tax free.

While a large majority of these advanced planning strategies are most advantageous while both spouses are living, there is still planning that can be done if you are already a surviving spouse. It is important to consult with tax and retirement specialists during all phases of the retirement planning process, both before and after the first spouse passes away. With all financial decisions, plan ahead as much as possible, and consider the survivorship implications of each of those decisions wherever possible. Thoughtful planning can have a significant positive impact on a surviving spouse during an already difficult time.

April Reed Crews is the CEO of Reed Financial Group in Snellville, Georgia and a member of Ed Slott’s Elite IRA Advisor Group.

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