I'll bet you've never heard of the “widow's penalty”. That's because it's a topic that doesn't usually come up until you reach retirement age. But it's actually a seriously important issue if you are easing into retirement and will have substantial retirement income.
We got an Ask GFC question about this very topic only recently:
“Both my wife and I have pensions of $44k. We also have a 403(b) with a total $250,000. We met with an advisor who mentioned a potential widow's penalty. By doing a Roth conversion we would eliminate that because no RMD is required with a Roth. There are upfront tax implications as we know. Do you think it is worth doing?”
Unfortunately, the reader didn't give us all of the relevant information needed to make a more precise call on this proposed move.
But there is enough to take on the topic, explain what it is, and make some comments and recommendations on the strategy that his advisor has proposed.
What is the “Widow's Penalty”?
The widow's penalty is one of those built-in conflicts within the federal income tax code. Briefly, what it means is that the tax rates for married couples filing jointly are much more generous than what they are for a single person.
This becomes a problem in retirement because once a spouse dies, the other spouse can experience a sudden and unexpected increase in his or her income tax liability.
That's because retirees typically live on fixed income sources, such as pensions, Social Security, and distributions from qualified retirement plans. That income may fall only slightly, or even not at all, upon the death of a spouse. That means that the surviving spouse – the widow – will suddenly find his- or her-self pushed into a much higher tax bracket.
And to add insult to injury, it's usually a higher tax liability even though it's based on a reduced income. And even worse, there's even an element of tax creep as the widow gets older.
Here’s the problem:
Once your spouse dies, you are entitled to file as married filing jointly only for the year in which the spouse's death occurred. After that, you must file as single. There are two factors that work against you in this regard, income tax brackets and deductions.
- Income tax brackets. The problem here lies in the graduated tax rates that the income tax code is built on. For 2017, the dividing line between the 15% tax bracket and the much higher 25% tax bracket is $75,900 for married couples, but only $37,650 for single filers.
- Deductions and exemptions. The situation is similar here. A married couple is entitled to a standard deduction of $12,700, while a single person is entitled to just $6,350. Since many retirees pay off their mortgages before retiring, they file their income taxes using the standard deduction, rather than itemizing.
Personal exemptions are $4,050. But when a spouse dies, the surviving spouse no longer has two exemptions, but just one. That means that the tax deduction for personal exemptions drops from $8,100 to $4,050.
If we put the standard deduction and personal exemptions together, they fall from $20,800 for a married couple, down to $10,400 upon the death of one spouse.
But one spouse dies, and the following year, the widow must file as a single taxpayer. Her income drops by just $20,000 as a result of the loss of her husband's Social Security benefit (we'll discuss this in more detail in a little bit). All other income sources remain the same. That means that her gross income is now $80,000.
She can take deductions totaling $10,400, which reduces her taxable income to $69,600. Of that total, $37,650 is taxed at 15%. But the remaining income above that threshold – which is $31,950 – is taxable at 25%.
While her spouse was alive, the couple's federal income tax bill was $12,210. But since the spouse’s death, the widow is now subject to a tax of $13,628.
But it doesn't end there. There are two more factors that can make this scenario even worse.
The RMD Complication
The reader uses the term “RMD” as one of the reasons for considering the Roth conversion. RMD refers to required minimum distributions. These are distributions required by the IRS on all tax-sheltered retirement plans (except the Roth IRA), beginning at age 70 1/2.
That means that even if the retired couple, or the surviving spouse, were to avoid taking retirement distributions in the early years of retirement in order to keep their tax liability lower, they will become a legal requirement at age 70 1/2.
Should one spouse die before this age, the widow will be required to take RMD's from all retirement plans that the couple have, as these accounts are generally not reduced as a result of the death of one spouse.
RMDs are based on your remaining life expectancy at a given age. Based on the standard RMD calculation a retiree will be required to take a distribution from her retirement accounts equal to 3.65% of the combined account values. But by age 80, the percentage rises to 5.35% based on a shorter life expectancy at that age.
Following the example given above, that will add $4,563 ($18,250 X 25%) to her tax liability just in the first year that RMD's are required.
But since RMD distribution percentages rise with age, she'll be required to take 5.35% of the retirement assets at age 80. This will add $26,750 to her taxable income, which will add $6,688 ($26,750 X 25%) to her tax liability.
The Social Security Complication
There's more bad news on the widow's penalty front coming from Social Security.
To begin with, Social Security is only partially taxable. But the higher your income is, the more of your Social Security will be taxable. This also works against single filers.
To begin with, if a married couple are both receiving Social Security and one dies, the surviving spouse can take the higher of his/her own benefit, or that of the deceased spouse. So if the husband is receiving $30,000 and the wife gets $20,000, the wife will be entitled to $30,000 upon the death of the husband. This is partially why the income of a retired couple doesn’t drop all that much in the event of the death of one of the spouses.
If you are married filing jointly, 50% of your Social Security income is taxable if your income from all sources is between $32,000 and $44,000. If your income exceeds $44,000, then 85% of your Social Security will be taxable.
But if you are single, 50% of your Social Security will be taxable with a combined income of between $25,000 and $34,000. If your combined income exceeds $34,000, then 85% of your Social Security becomes taxable.
These thresholds don't apply to the example that we've been using thus far, because the combined income for both the retired couple and the widow exceed these limits. But if her income were closer to the income figures listed just above, the death of a spouse could easily push more of the Social Security income into the taxable realm.
What this means is that a widow can see her income tax liability rise due to four factors:
- More income taxed at higher rates
- Lower exemptions and deductions
- Higher taxability of Social Security income
- More taxable income as a result of RMD's, which were not a factor before turning age 70 1/2
This is a long-winded explanation for why preparing for a potential widow's penalty is so important.
Using a Roth IRA Conversion as a Partial Solution
Due to the unfortunate structure of the IRS tax code, it's probably not possible to completely avoid the widow's penalty. But a Roth IRA conversion could alleviate at least part of the problem.
The basic idea is to move retirement money from other types of retirement plans, including traditional IRAs, 401(k) plans and 403(b) plans, into a Roth IRA, doing a Roth conversion.
Roth IRA Conversion Tax Considerations
While a Roth IRA conversion will avoid the tax problems that come with RMDs, it's important to remember that a Roth conversion will usually result in including the amount of the funds converted in your current taxable income.
This is usually best accomplished in retirement, since income is typically lower than what it is during the working years. However, it should be done before turning age 70 1/2, since by then RMD's will have already kicked in. What that means is that there is a window between retirement and turning age 70 1/2, when a Roth conversion is best accomplished.
Whether or not this will make sense for the reader and his spouse will depend upon the potential tax impact of the widow's penalty, compared with the amount of tax they will pay on the Roth conversion.
The reader indicates a value of $250,000 in their 403(b) plans, which can easily push them into higher tax brackets $250,000 in their 403(b) plans on conversion, such as 28% and higher. That could produce an additional tax liability of upwards of $70,000. For that reason, it will be best to convert that amount of money over several years, to keep the tax impact of the conversion to a minimum. That’s a strategy that they will have to work out with their tax preparer.
The couple will also have to consider the taxability of their Social Security benefits in connection with the Roth conversion. The conversion itself could make more of the Social Security income taxable. The conversion will be better if it’s done before they begin collecting Social Security, if they haven’t already.
The couple do have one major advantage. The reader indicated that they live in New Hampshire and Florida, which are two states that have no standard state income tax. This will at least eliminate the complication of having to pay state income taxes for the Roth conversion, on top of federal income taxes.
The widow's penalty requires a pretty complicated strategy, and one that will be based entirely upon individual circumstances. It's always best to work out this kind of strategy with your CPA or tax preparer, that way you can make sure that the taxes that you will pay for the Roth conversion won’t outweigh the benefits that you will receive in minimizing the widow's penalty.