Couples Planning For Retirement {Widow’s Tax Trap}

If you are married and planning for retirement it's important to not overlook the widow's tax trap. Certainly it's important to make sure that you are planning to have all the income that you need to sustain the lifestyle that you want to have all throughout retirement even if both of you live a long life. However, it's also important to understand how your retirement plan could be impacted when one spouse passes away. 

When one spouse dies the surviving spouse is going to have to file as a single person and will also lose a Social Security check assuming you were collecting Social Security. Often times the surviving spouse has to pay more in income taxes while at the same time living on less income.

In this video I walk through a sample case study and look at some different scenarios. I also discuss a couple of possible solutions to help reduce this risk.

Full Transcript:

(00:00):

If you're married and you're planning for retirement, then of course it's important. You want to make sure that you're planning so that you'll have all the income that you need in order to sustain the lifestyle that you want to have all throughout retirement, even if both of you were to live for a long time. Now, one of the mistakes that I see that gets made far too often, unfortunately, is not planning for what would happen if one spouse were to pass away early. So in this video I'm going to explain the widow's tax trap. We're going to look at some examples, dive into a little detail here and look at a couple different scenarios, and I'll also share with you a couple of things that you may want to consider to help mitigate this widow's tax trap. So let's dive in To explain this, I just put together a very simple case study here.

(00:51):

This is Adam and Anna Sample fictitious couple here, obviously, and they are both 66 years old. They both have $500,000 in their IRAs. So combined, they've got a million dollars in investments here, and Adam's Social Security benefit is $3,000. If he takes that, his full retirement age, which is 66 and eight months, and Anna's the same thing, so I also gave her a $3,000 benefit if she takes it at her full retirement age. And again, her full retirement age is also 66 and eight months. Now their goal is to be able to spend $7,500 a month after taxes. So this is an after tax number here. This does not account for healthcare expenses. I factor that in separately. I'm not even going to get into that here. So right now, and here's the interesting thing. So right now, if they both were to live a relatively long life anyways, I'm assuming here he lives to be 88 and that she lives to be 93, they have an 89% probability of success.

(02:05):

So that's really good. Anytime I see a number here that's higher than 85%, that's really where we want to be. I don't want to get into a lot of detail on this, but if we're way up here like at 98, 99%, then arguably we're not spending enough money. So keep in mind if things needed to be adjusted in the future, they could adjust their spending. Look at the confidence scale here. As we can see, it doesn't even show them perhaps running out of money here until she is 91. So again, they're looking really, really good as it stands right now today, if both of them were to live a long life. Now here's where the problem comes in, and this is the widow's tax trap. So I'm going to pick on Adam here, and I'm going to assume now that Adam passes away next year.

(03:02):

Now, if that were to happen, you're going to see this probability of success number drop dramatically down to 43%. So why does this happen? Well, let's look at the cash flows here and let's actually look first if they both were to live until life expectancy. So if Adam does not pass away next year, then what's going to happen is of course both of those Social Security checks are going to continue to come in the $3,000 a month, which is $36,000 a year total is $72,000. And to meet their living expenses, they're only going to have to withdraw just under $32,000 from their IRAs to do that. And their taxes are going to be very minimal. I mean only about $2,800 here this year. So these are their expenses, right? $101,000. I mean, again, they would be looking very good in this scenario. In fact, as we scroll down here at age 73, this is when they'll have to start taking out the required minimum distributions.

(04:12):

And in their case, this is the projected amount that they'll have to take out combined and they'll actually have some extra money left over, and in fact, there's an extra about $2,300 here that they're being forced to take out that they don't even need to and having to pay tax on. And I'm just assuming here that they're going to go ahead and reinvest that at that time. So again, they look really good. Now, going back to if Adam passes away next year, now what we're going to see is a noticeable impact in a few different areas, including of course right here, this tax column. So notice here this first year if Adam's alive, they're both alive, they're getting $72,000 from Social Security. They're only taking about $32,000 here from the IRAs. Their taxes very, very small. Now, he passes away that next year when one spouse passes away, keep in mind, you're going to lose a Social Security check.

(05:15):

You'll keep the higher of the two. In this case, they both were going to get the exact same amount. So one check goes away, the other check is kept, and so her benefits are now cut in half. So what does that mean? Well, what that means, even though I'm assuming she's going to spend less money, she's now going to spend 15% less when he passes away. She's still going to need to withdraw a lot more here, more than double the amount from the IRA in order to meet those living expenses. And because of the way that Social Security is taxed, which is based upon the provisional income formula, which I won't dive into a ton of detail here, although I will share the 1040 here in just a second, I've done other videos about that. But what's happening is she needs a lot more money from the IRA in order to meet her living expenses, which again are reduced after he passes, and her taxes are considerably higher here than they were in the year before that.

(06:21):

Let's take a look at that 1040, as you'll see right here. Let's look first if they're both alive. Current plan. Now they're both alive in 2026. We can see their total Social Security is 73,800. Right here. The taxable amount is only $30,000. Again, because the way that Social Security is determined, whether it's going to be subject to tax is based upon the provisional income formula or tables. If you only receive Social Security, you will not pay taxes on Social Security at the federal level. It's only other income that could cause Social Security to become taxable. So in their case, this is the amount that's taxable, a very relatively small amount, less than half, much less than half. Now, what happens here is that when he passes away and then she has to file as a single person here in 2026, you'll see of course the Social Security benefits.

(07:30):

Again, were cut in half, so these are much lower, but the taxable amount here is very, very high. You'll never pay taxes on more than 85% of your Social Security benefits at the federal level. 15% is always tax free even if you make 10 million a year. But in her case, the amount of her Social Security benefits, percentage wise anyways, is much, much higher. And again, she's having to take a lot more from the IRA in order to meet those living expenses. Take a look here at the federal income tax bracket. If Adam did die next year, you're going to see she jumps from a 12%, which will become the 15% when the Tax Cuts and Jobs Act sunsets. But instead of her being in the 15%, which is what they would be as a married couple, she now jumps up to 25% for the rest of her life. And let's just take a look at that. If they were married, both living a long life, they get into that 15% when the tax cuts and Jobs Act sunsets, it's not until down the road here at age 82 that they get boosted up here into that 25% bracket, I should say. So one of the reasons we're seeing

(08:54):

that, by the way, is that the tables that you take a look at for the provisional income for Social Security, those dollar amounts have not changed since the 1990s. And so as their income is going up naturally, more and more of their Social Security is becoming subject to tax, which makes more and more income overall taxable. So that's kind of what we're seeing here. So what are some different things that they may consider doing? Now, I've talked about this in other videos, so I'm not going to dive into a lot of detail here on this, but one solution here would be incorporating Roth IRA conversions into the mix. Now, my sample couple here, I only assume that they just had this million dollars, 500,000 in their respective IRAs, but maybe if it's a different situation, they'd get other money that's on the sidelines. For instance, sitting in cash, maybe they could use that money to help pay the tax and incorporate some Roth conversions into the mix.

(10:06):

That could be one strategy. And then we would want to take a look at what makes sense and what possible improvements that could have. Remember, if you do a Roth conversion while you're married, again, you're doing it based upon if you take the standard deduction, both of you have your standard deduction, and of course tax brackets are more favorable, being married and then down the road, that single person who's taking out money from that Roth IRA is taking it out without having to pay taxes. And so that can help out tremendously to help incorporate that. Another possible solution could be life insurance here. And the type of policy that we typically look at, and I know a lot of people are kind of surprised sometimes they think, well, in retirement I didn't think about even needing life insurance. Sometimes it makes sense. Again, at its core, life insurance serves the purpose of replacing income.

(11:03):

And so if one spouse loses a Social Security check, that might be income that needs to be replaced. Of course, now they're filing single, so it makes it even more difficult. Having that additional cash can make sense. This is where sometimes we might look at like a 10 year term policy, which with most all carriers anyways, that's the shortest time period that they offer. And it doesn't mean you have to keep it for 10 years, it's just whatever rate you get locked in at. If it's a 10 year level term, the insurance company has to offer that to you at that rate for those 10 years as long as you continue to pay the premium. But if you reevaluate your situation, maybe in 5, 6, 7 years you don't need it anymore, you can just drop it, save the money, and not pay the premium. That could

(11:52):

make some sense. So those are just a couple of different solutions that you may want to incorporate here. Hope this has been helpful. Hopefully you understand now what the widow's tax bracket is all about. And although it's so important to make sure if you're a married couple that you're planning for, in case both of you are to live a long life, that you do have all the money that you need all throughout your retirement years, it's also hugely important to plan for if one spouse were to pass away early or beyond the scope of this video were to have extended healthcare issues and incur those types of costs, and whether it's long-term care or what have you. So hope this has been helpful. If it has, make sure that you like the video. Make sure that you subscribe and have a good day. See you soon.