Take-Away: Many of us have heard of the so-called ‘Marriage Penalty’ with regard to income tax liabilities. Less known is the concept of the ‘Widow’s Penalty’ (or the ‘Widower’s Penalty.’) The 2017 Tax Act actually made the Widow’s Penalty even worse in some situations when it broadened the federal income tax brackets for jointly filed income tax returns, the result of which is that a widow (or widower) may find themselves paying federal income taxes at a higher marginal income tax bracket, on similar or even lower reported taxable income.

Background: When one spouse dies often, the surviving spouse’s taxable income will be roughly the same as before the one spouse’s death. While some Social Security retirement will disappear, it will be the smaller of the two Social Security checks that ceases to be paid. However, the joint standard deduction will be replaced by the single standard deduction for the survivor. The result may actually be an increase in the survivor’s reported taxable income. That taxable income will be subject to higher income tax rates reflected in the single taxpayer’s tax table. All of which leads to the Widow’s Penalty.

Year of Death Exception: In the year that one spouse dies, the widow (or widower) is still eligible to file an income tax return using the ‘married filing jointly’  tax filing status. Thereafter the widow (or widower) must file as a single taxpayer, leading to all sorts of tax consequences.

Example: Bill and Hillary are both age 73. Last year Bill and Hillary owned a $900,000 IRA that generated over $36,000 a year in required minimum distributions (RMDs.) They also received pension income over $30,000 and combined Social Security retirement benefits of $42,000. Using the married filing jointly status, Bill and Hillary’s taxable income for last year was about $75,000. The federal income tax on the $75,000 taxable income was $9,000. Bill dies at the beginning of 2019. All of these income items remain the same, but for Social Security income, which will fall for Hillary from $42,000 to $28,000. Thus, Hillary’s income will drop by $14,000 for 2019, due to the loss of the smaller of the two Social Security checks. Hillary’s standard deduction will also drop from $27,000 to $13,850 in 2019, which is the single taxpayer’s standard deduction amount for 2019. The result of all of these ‘moving parts’ is that Hillary’s federal income tax liability will go from about $9,000 in 2018 to around $13,000 in 2019, as she will have gone from a 12% income tax bracket to a 22% income tax bracket (an increase of about 40%.)

Social Security Tax: The example above assumed that 85% of the Social Security benefits Bill and Hillary receive will be subject to the maximum income tax- 85% is taxable and 15% is untaxed. Moving from a joint to single taxpayer status will introduce new thresholds for the taxation of Hillary’s Social Security benefits. Thus, an increase in income tax on Hillary’s Social Security benefits will occur in addition to a higher income tax on Hillary’s other reported income.

Net Investment Tax Exposure: Another tax trap for a widow (or widower) is their exposure to the 3.8% surtax on net investment income. This surtax is triggered at $250,000 of reported modified adjusted gross income (MAGI) for married couples and $200,000 MAGI for a single taxpayer. A married couple could avoid this 3.8% tax with $240,000 MAGI, but a widow with $226,000 MAGI (after losing just the smaller Social Security check) would have to pay the surtax.

Medicare Premiums Increase: A widow might find that future Medicare Parts B and D premiums will increase after her spouse’s death. A married couple who report $150,000 of MAGI in 2018 would both pay the basic monthly rate of $135.50 for Part B coverage or a total of $271 a month for the two spouses.  With the same MAGI in 2019, a single widow will pay about $352.20 a month in Part B premiums.

Add all of these changes together, e.g. the drop in the standard deduction amount, the Medicare surtax exposure, the increase in Medicare premiums, and it is understandable why a Widow’s Penalty results when a surviving spouse does not remarry.

Mitigating the Widow’s Penalty: The key to address the Widow’s Penalty is to act while both spouses are alive. One common strategy is to accelerate income and expose it to the more favorable joint return income tax brackets.

Example: Consider a couple who report about $100,000 a year in taxable income. They could start to receive Social Security at age 62 years of age. They are at the 22% marginal federal income tax bracket with $100,000 in taxable income. Rather than start taking Social Security (at a big discount) at age 62 years they instead each take distributions from their IRAs. Since they are both over age 59 ½ there is no early withdrawal penalty imposed on the IRA distributions. Assume each spouse takes a $30,000 withdrawal from his or her IRA at age 62. That distribution will be taxed at the 22% tax rate (the 22% income tax bracket for 2019 rises to $168,400.) The net amount after the $6,600 is paid in income taxes from the $30,000 IRA distribution is $23,400. The spouses might live on the net $23,400 and delay starting to take Social Security benefits. They might use the after-tax amount of $23,400 from the other IRA distribution, if not used for living expenses, to convert it to a Roth IRA. The Roth IRA will provide to them, and to the survivor, tax-free income in their retirement years. By delaying taking Social Security until age 70 years, that will result in a larger payout (32% more than the Social Security  benefit would be at normal retirement age 67) which will be partially (15%) income tax-free, thus producing a larger after-tax payout overall to the surviving spouse for his/her lifetime.

Conclusion: The Widow’s Penalty should be discussed with married clients before they decide to retire. Projections should be run to show a married couple the income tax consequences when one spouse dies. Included in those projections should be identifying which assets should be liquidated first to support lifestyles, including the benefit of withdrawing IRA assets and exposing that taxable income to the marginally lower income tax bracket of a married couple, and the benefit of converting traditional IRAs to Roth IRAs on the cusp of, or early into, their retirement years