From joint to single filer: Unintended tax consequences for surviving spousesArticle added by Jeff Reed on May 15, 2014
San Diego, CA
Joined: May 07, 2012
Ranked: #31 (1,737 pts)
I have written before about the need for considering tax diversification in retirement planning. The tax-erosion of retirement income is something that every retirement planner needs to take seriously. Building on that theme, planners must consider the potential tax effects of the first spouse passing away during retirement, leaving the surviving spouse with unintended consequences that can dramatically affect their lifestyle.
No matter what stage of life, there is nothing that can prepare one for the loss and emotional maelstrom that comes with losing a spouse. With so much to go through, accept and adapt to, the last thing anyone wants to think about is the impending income tax consequences.
Change in filing status
The tax code allows for a filer to retain a "married filing jointly" status for the tax year in which a spouse passes. However, the following tax year will require a change in filing status. Without proper planning, the realities of the filer status change that happens within two years of the first spouse passing will surely set in, and it can wreak further havoc. The change in filing status can have rather onerous tax consequences on the surviving spouse’s income, causing the surviving spouse to receive a significant reduction in after-tax income.
Consider a retired couple, each age 68, taking the following distributions:
Their total retirement income is $73,000.
- $19,000 per year from a 401(k)
- $22,000 per year from an IRA
- Joint Social Security benefits of $32,000 per year
When the spouse passes, the financial consequences for even those who have planned for retirement can be dramatic. Going forward, the surviving spouse will only receive one Social Security benefit. In this example with the 68-year-old couple, that translates to a 34 percent reduction in Social Security income, from $32,000 while married to $21,000 as a widow. To make up for the loss of Social Security income, the widow must take larger distributions from both the IRA and 401(k) in order to receive the same total income of $73,000. Because of changes in the source of her income, however, the amount of Social Security income excluded from tax has been reduced from 50 percent to 15 percent. And the pain doesn’t end there.
Now, as a single-filer, her standard deduction (assuming no itemized deductions) has been cut in half, and she has only one personal exemption. In this example, despite her total income remaining equal to what it was while her husband was alive, her taxable income has increased by over 58 percent. Under the 2013 income tax tables, the joint-filing couple would have had a marginal federal income tax bracket of 15 percent. With the change in filing status the following year to single, the same $72,000 income will result in a 25 percent
marginal federal tax bracket (assuming the same tax brackets remain in place).
If the widow in this example is a California resident, the change in filing status results in a combined federal and state tax increase of
158 percent. The widow’s after-tax income is reduced by 13 percent, which for some can mean a material change in lifestyle.
IRA and cash value life insurance alternatives
So how can you avoid this kind of planning pitfall? Consider the planning vehicles that offer the greatest tax leverage. While there is tremendous influence encouraging workers to contribute to 401(k)s on a pre-tax basis, it may be wise to consider Roth IRAs and cash value life insurance in addition or possibly as an alternative (you probably don’t want to skip an employer match).
Roth IRAs and cash value life insurance are phenomenal tools for retirement planning. They enjoy tax-free growth and tax-free income in
retirement (if the life insurance policy is properly structured and managed). Life insurance provides the further flexibility and leverage of the tax-free death benefits paid to beneficiaries. Imagine how the couple I have described could have benefited from the use of life insurance policies in their retirement plans.
First of all, if they had allocated a portion of their retirement investment dollars into accumulation-oriented life insurance policies, those funds would have grown tax-free. Well-constructed policies could have produced tax-free income in retirement for both the husband and wife. That would have lowered their tax liability versus the exposure of all of their non-Social Security retirement income to tax.
Additionally, with lower taxable income may come a lower tax bracket. The amount of Social Security retirement income that can be
excluded from tax could end up being much more favorable for the couple both while married and after the first death.
Lastly, and perhaps of greatest importance, the tax-free death benefit would be payable at the first spouse’s death. The liquidity would allow the surviving spouse flexibility to do things that are needed to be done financially as she adapts to the many life changes. One more thing to consider when contemplating the evaluation of life insurance as a proper retirement planning vehicle is the ability to incorporate long-term care riders.
The couple would be in real financial peril if either triggered the need for long-term care. At $73,000 of retirement income, they would not have the ability to pay the full cost of just one of them needing full-time care, given today’s costs. They’d almost certainly be liquidating assets such as a home to fund those expenses. The inclusion of long-term care or even chronic or critical illness benefits in a life insurance policy gives a retirement plan that much more potential to be successful.
I am not advocating that life insurance policies should be recommended instead of 401(k)s, Roth IRAs, pensions or traditional IRAs. I am
suggesting that incorporating the use of properly designed life insurance in retirement planning can yield an outcome that is much more secure and guards against the potential erosion of income by taxes. Planning with the end in mind — and protecting against all potential threats — is a key part of retirement planning.
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