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Losing a spouse is devastating, and survivors often face an expensive windfall in increased future taxes. But experts say couples can plan ahead to ease the burden.
This problem, known as the “survivor penalty,” occurs when married couples move from filing jointly to filing separately, and can result in higher tax rates for some couples. Single filers have lower tax brackets, lower standard deductions, and lower thresholds for other tax breaks.
Gregory Fuhrer, CEO and founder of Beratung Advisors in Pittsburgh and a certified financial planner, said this is one of the “most overlooked and financially damaging tax events.” And it often appears at the worst possible times.
Financial experts say survivorship penalties could affect heterosexual couples, who typically have different life expectancies, and could require multi-year tax planning.
According to the latest data from the Centers for Disease Control and Prevention, there will be a difference in life expectancy of more than five years between men and women in 2023. The average life expectancy in 2023 will be 81.1 years for women and 75.8 years for men.
Fuhrer says that if you inherit an individual retirement account from a deceased spouse, it may result in a higher required minimum distribution (RMD) for single filers in a higher tax bracket.
This could result in, among other things, higher federal income taxes, higher Medicare Part B and Part D premiums, and higher Social Security taxes. “This is a tax trap that hits widows and widowers at a very vulnerable time,” he said.
Surviving spouse may lose “flexibility”
Converting a Roth to an individual retirement account, which some investors use for legacy planning, could result in a surviving spouse paying higher taxes, experts say. This strategy incurs an upfront cost, but allows you to start growing tax-free for your heirs.
“It reduces flexibility,” said CFP Edward Justrem, chief planning officer at Heritage Financial Services in Westwood, Massachusetts.
Survivors may also end up paying more if they make large withdrawals from pre-tax accounts. For example, let’s say you need cash to buy another home. If you withdraw $300,000 from your IRA before taxes, you could end up paying higher taxes as a single filer, Justrem said.
Additionally, for single filers, higher incomes can cause additional taxes to accrue sooner, he said. You can pay the so-called net investment income tax sooner, which applies to things like capital gains, interest, dividends, and rent. You may also lose eligibility for certain tax breaks.
How to reduce the survivor penalty
Typically, “active planning” takes place five to 10 years before retirement, when there is still time to “shape future tax outcomes,” said Führer of Beratung Advisors.
For example, some couples may consider “strategic Roth conversions” to reduce pre-tax retirement account balances or future RMDs for survivors, he said.
Of course, you’ll need to run a multi-year forecast to see when you’ll pay taxes on the converted balance.
They also need to plan for their retirement income, such as when to receive Social Security benefits and withdrawals from pensions and taxable investment accounts, which can help “soften the impact on the surviving spouse,” Führer said.
