How Losing a Spouse Could Boost a Survivor's Taxes

Switching to a single filing status and a few other changes that occur after losing a spouse could mean a dramatically higher tax bite. But there are ways to ease that burden.

The death of a spouse is especially devastating if the loss also leads to financial insecurity.

And yet, I often meet couples who have spent little time thinking about what could happen if one dies years before the other.

These days, we tend to stress how long people live and the importance of having enough saved to cover what could be 30 or more years of retirement for two people. But it's also crucial to consider the income and tax consequences if one spouse is left alone.

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An income plan could change drastically, depending on whether both spouses were included in any pension-plan benefits. And the surviving spouse will receive only one payment from Social Security—whichever was the larger of the two.

A One-Two Tax Punch

But what really catches people off guard is that the income-tax table the surviving spouse uses will change as well: She'll go from married filing jointly to single status, and her standard deduction and exemptions will be reduced by half. That means more of her income will be taxable, and at higher rates. (And, yes, although either spouse could live longer, typically it is the wife who is left behind because, throughout the world, women have a longer life expectancy than men.)

And here's a 21st-century insult to add to this injury: All the money that's piled up in a couple's tax-deferred saving accounts (401(k), 403(b), traditional IRA, etc.) will be 100% taxable when it's withdrawn. So the surviving spouse likely will be adding even more to her tax burden.

An Example of What Could Happen

Let's look at an extremely simplified example with a hypothetical couple from the future: George and Jane.

George and Jane have a combined $30,000 from Social Security, and they're pulling another $30,000 from an IRA. Because they're married filing jointly, only 23% of their Social Security is subject to income tax, so George and Jane have $60,000 in income, but only $36,850 is subject to federal taxes. Their standard deduction and personal exemptions erase about $23,200, which means they have a taxable income of $13,650. They're in the 10% tax bracket, and they pay $1,365 in federal taxes.

Now, let's say poor George passes away unexpectedly, and Jane is left on her own.

Some expenses may change, but not some of the biggies—property taxes, home and auto insurance and utilities. Jane actually may spend more on food (because she's eating dinners out with friends) and travel (for frequent visits to daughter Judy).

Jane will get the higher of the couple's two Social Security payments, but it's only $20,000 per year. So to keep the same lifestyle she had when George was alive, she'll take more out of her IRA—$40,000. But here's the surprise: Now 85% of her Social Security will be subject to income tax, because the amount she'll pay is based on a different table meant for single filers. Jane will have $57,000 of taxable income, but only one exemption and half the standard deduction. Her taxable income will be $45,100—putting her in a 25% tax bracket—and she'll pay $7,046 in federal taxes, a 416% increase!

Unless she gets busy, that is.

A Life Insurance-Roth IRA Strategy

Jane can still file as married filing jointly in the year of George's death, which gives her the opportunity to make a lot of changes—including using George's life insurance to pay the taxes when she converts that old traditional IRA to a new Roth IRA. Going forward, there would be no taxes on the distributions she takes (after holding the account for five years, within the first five years of conversion, she may be taxed on the gains)—and no required distributions when she turns 70½. Jane would have much more control over her tax rates as opposed to being stuck.

All it takes is some planning. And in this strategy, George's tax-free death benefit made it possible for Jane to convert to a Roth IRA.

Like being too rich or too thin, it's hard to leave somebody too much tax-free money. In this case, Jane saved $7,046 in federal taxes during an emotional time when she really didn’t need the extra worry. And she'll continue to save on her taxes every year.

Tax-Free Assets a Key to This Plan

Often as people approach retirement, they realize they no longer need life insurance for the traditional reasons—to pay off debts or to replace income lost when the primary wage earner dies. But before you start canceling policies—or taking cash out of them—talk to your financial adviser about how you could use your insurance in a strategy to mitigate taxes.

There are only three assets that are currently tax-free—Roth IRAs, interest on municipal bonds and life insurance proceeds.

These assets could come into play when you least expect it—and when you need help the most. When you're alone and grieving, you shouldn't have to worry about losing your lifestyle to unexpected taxes.

Freelance writer Kim Franke-Folstad contributed to this article.


This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Eric Peterson, Registered Financial Consultant
Founder, CEO, Peterson Financial Group

Eric Peterson is a Registered Financial Consultant (RFC) and founder of the Peterson Financial Group. He is the author of "Preparing for the Back Nine of Life: A Boomer's Guide to Getting Retirement Ready."