Avoid the Tax Trap Most Couples Don't Want to Think About

When we meet married couples, they typically have a “We’re in this together” attitude about financing their retirement.

And that’s good. It’s a big plus when spouses are on the same page with their planning.

But, of course, they won’t be in it together forever. Which means at some point we have to discuss the uncomfortable truth that someday — hopefully far down the road — one of them will be widowed. One spouse will be on his or her own most likely for at least a few years. And what happens to that person financially is something they both should think about long before it happens.

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Because even if everything stays the same regarding the widow or widower’s lifestyle and income (and that isn’t always a given), his or her tax status will definitely change within a year or two after the death occurs — from married filing jointly to single or head of household. And that change can cause a startlingly large tax bill for those who are unprepared.

Married vs. Single: An Example to Run the Numbers

How much of a difference could there be?

Well, let’s say a married couple will have $80,000 in taxable income this year and will file a joint return. That puts them in the 22% bracket, which means they’ll owe $9,317 in federal taxes for 2019. Meanwhile, the 71-year-old widow who lives across the street from that couple, a single filer with the same $80,000 in taxable income and the same 22% bracket, will owe $13,458. To come close to what her married neighbors will pay, she’d have to cut back to about $62,000 in taxable income. And that could be difficult if a large portion of her nest egg is in an IRA or some other tax-deferred retirement account — which frequently is the case.

Savers who have all or most of their retirement money in an IRA often don’t realize they owe a looming debt to the IRS. That debt will come due when they start withdrawing money in retirement and have to pay federal income taxes on those withdrawals. And even if they don’t need the income, the IRS requires them to start taking minimum distributions at age 70½.

That can cause problems for any retiree — married, single or widowed — especially if tax rates (which are currently low thanks to recent reforms) go up in the future. But for those whose filing status changes in widowhood, it may require unexpected and drastic adjustments.

To add to the uncertainty, often a portion of those IRA dollars are invested in the stock market, exposing them to market risk. If the market declines when the funds are needed for income, it could cause further issues.

Two Strategies to Consider That Could Help

Nobody we talk to wants to leave their spouse with an uncertain future. So we discuss the things they can do now to lower those risks later.

One option is to move their money from that tax-deferred traditional IRA into an after-tax Roth IRA. That means paying taxes on any funds they convert now, but at a lower tax rate than they likely will see in the future. And the money in the Roth can continue to grow tax-free.

Another option for some retirees is to transition the money to a properly funded life insurance policy — in particular, a hybrid policy with long-term care benefits that could help pay for a nursing home someday or other qualifying costs that might come up in later years.

We’ve met with many couples who have $1 million or more in an IRA, and they’ve already mentally set aside $250,000 for long-term care costs. They know those expenses are probably coming; they just haven’t purchased a long-term care policy to cover them. And with good reason: Traditional long-term care insurance is getting more expensive and harder to find all the time.

Hybrid policies are gaining in popularity because they can offer more flexibility than insurance policies that offer only death benefits or only long-term care.

If something happens to a policyholder’s health, they have it covered. If they need funds down the road, they can access the money they’ve put into the policy, plus interest. When they die, the money that’s left in the policy will go to their beneficiaries — tax-free.

And if they pay for the policy with money from an IRA, they’ll have dodged a tax bullet as well.

Yes, this plan also requires paying taxes on IRA funds as they’re withdrawn to pay premiums, and that may hurt a bit as it occurs. But this is about long-term planning — a little pain now in exchange for less worry later. The sweet spot for converting the money is after age 59½ (to avoid the 10% early distribution penalty) and before age 70½ (when those required minimum distributions kick in).

Because these types of hybrid policies keep evolving, it’s important to work with a financial professional who is well-versed in insurance as well as all other aspects of retirement planning. Ask about the pros and cons, and run the numbers to make sure this is, indeed, a fit for your overall plan.

Then make the decision together, as a couple, because the security this strategy can offer is meant to benefit both of you.

Kim Franke-Folstad contributed to this article.