There are ways to rein in the additional impact of the Widow’s Penalty on the survivor’s finances. For couples, planning for this now is essential.

The phone rang, and Barbara saw her tax accountant’s name pop up. She had worked closely with him after Jim died and he had helped her figure out how she could cover all her expenses without that second Social Security check. Barely. They had filed that first year of taxes and had made it work. “Barb,” he said. “I hope you’re sitting down. I just ran the numbers for this year’s tax return, and you’re going to have to come up with an extra $1,950.”

How could that happen? Well, by IRS regulations, she was entitled to file as married filing jointly for the year Jim died. But after that, she’d have to file as single. And the second year is when the infamous Widow’s Penalty really kicks in.

For years, we have heard about how widows are adversely affected by tax codes that make an already difficult time even more devastating. And this phenomenon has been named the Widow’s or Widower’s Penalty.

What exactly is the Widow’s Penalty?

The Widow’s Penalty is what happens to the tax burden of a surviving spouse as a result of the IRS tax code. Let’s look at it through the impact it can have in real life, using a hypothetical couple we’ll call Deb and Pete.

Deb had a career with a large firm, and Pete owned a small business. Both are now retired, and both receive monthly Social Security checks: $2,500 to Deb and $1,500 to Pete.

When Deb retired, she started receiving a monthly pension of $2,500, or $30,000 per year. Pete has no pension.

They also have traditional IRAs worth around $400,000. As they are both over 70-1/2, they have to take out Required Minimum Distributions, or RMDs. For them, this means about $15,000.

Let’s say that Pete passes away this year. How will Deb be affected next year?

How income will be impacted: Deb’s Social Security will drop from $48,000 to $30,000, losing Pete’s $18,000 (or $1,500 per month). The surviving spouse generally gets the larger of the two benefits, which in this case is Deb’s.

Deb’s pension will not be affected since it is in her name. She will get the same $30,000.

Deb will have to take out about the same $15,000 as RMDs (and be taxed on that sum) since the calculation is based on the total value of the couple’s tax-sheltered assets and she will likely have inherited any IRAs in Pete’s name. The RMD distribution percentages will increase with age (3.65% at age 70-1/2 and 5.35% at age 80), so the income tax burden will only increase.

All told, Deb’s gross income will fall $18,000, from the couple’s $93,000 to her $75,000.

How taxation will change: Deb will lose Pete’s standard deduction. Using 2019 IRS projections, instead of the $24,400 they would have deducted as married filing jointly, she will only receive the single person’s standard deduction of $12,200.

Deb will likely have the same percentage of her Social Security taxed because her combined income was above the threshold for 85% taxable, both when they filed as married jointly and when she files as a single taxpayer.

Deb will be in a higher tax bracket, thanks to bracket creep. Someone filing as single moves into higher tax brackets much faster than a married couple filing jointly. Using projections for 2019, the top of the 12% bracket for filing married jointly is $78,950 (and the couple’s Adjusted Gross Income falls within that maximum). The top of the 12% bracket for single filers is $39,475, and Deb’s income exceeds that considerably. Therefore, a good portion of her income will now be taxed at 22%.

What is the net effect? Deb’s income will drop by $18,000, while her tax burden will increase by approximately $1,700. Her spending power is reduced by nearly $20,000 per year. As the result of the Widow’s Penalty, a surviving spouse will face increased taxes at the same time as their income declines.

So, whatever you choose to call this penalty, making changes early on to shield the surviving spouse is a magnificent gift you can give to one another. Financial strategies such as conversions to Roth IRAs can lessen the future tax burden of RMDs. Social Security claiming strategies can also have an impact.

While nothing will soften the blow of the loss of a loved one, there are ways to rein in the additional impact of the Widow’s Penalty on the survivor’s finances. For couples, planning for this now is essential.

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