It's tough enough when a spouse dies. But at tax time, the survivor should prepare for another blow: a bigger tax tab, known as the widow's (or widower's) penalty.
When a spouse dies, the survivor's income could drop somewhat. But the tax-bracket thresholds for single filers are low relative to thresholds for joint filers. "A single person goes into the tax brackets faster" than joint filers, says Martin James, a certified public accountant in Mooresville, Ind. "All of a sudden, it's easy to get an increase" in taxes.
James recalls an older couple he advised. For 2012, the year the husband died, the widow was able to file a joint return. The couple's adjusted gross income was $91,000 and their taxable income was $66,000, which fell within the 15% tax bracket for joint filers ($17,400 to $70,700 in 2012). Her federal tax tab: $8,884. (AGI is total income less a few adjustments, while taxable income is AGI less personal exemptions and deductions.)
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In 2013, the wife's AGI dropped to $88,000. But her taxable income rose to $69,000, as a result of losing one personal exemption and of lower medical deductions. Her taxable income bumped her into the 25% tax bracket for single filers ($36,250 to $87,850). Her federal tax bill: $13,365. "If she was still married," James says, "they would have been at the top of the 15% bracket." That bracket topped out at $72,500 in 2013.
As a single person, the widow would likely be required to pay income-related surcharges for Medicare Part B and Part D for the first time -- about $640. (The trigger point for married couples is twice as high, AGI of $170,000 versus $85,000 for singles.)
For older retired couples, James says, "income doesn't change a whole lot" -- leaving many survivors in a higher bracket. Investment income is likely to remain level, for example.
Major expenses may not drop either, says Cindy Hounsell, president of the Women's Institute for a Secure Retirement. "She still has the house," Hounsell says, with its property taxes and maintenance costs.
The Tax Hit on Benefits
James says the widow's penalty has the most impact on retired taxpayers with modest incomes. After a spouse's death, he says, there's a greater likelihood that a higher percentage of the survivor's Social Security benefits will be subject to tax.
Consider a couple in the 15% tax bracket with $40,000 of AGI, not including $18,000 in Social Security benefits. Fifty-seven percent of their benefits would be subject to federal income tax -- for a tax bite of $1,538. After the husband dies, his wife's AGI drops to $35,000 and her benefit drops to $12,000. At that point, 85% of her benefit will be taxed -- for a tax tab of $1,530.
Higher-income survivors can get hit, too. The top 39.6% tax rate, for example, kicks in at $450,000 of taxable income for couples and $400,000 for singles.
There are steps couples can take to keep a survivor from jumping into higher brackets. "The biggest thing is to look at this while both spouses are living," says Jeffrey Levine, IRA technical consultant with Ed Slott & Co. "It should be part of an overall plan."
One strategy is to convert part of your traditional IRA to a Roth. If you're a couple in the 25% tax bracket, you can convert enough to take you to the top of the bracket over several years -- so your tax tab on each conversion won't exceed 25%. After one spouse dies, withdrawals from the traditional IRA "can be partially offset by tax-free income from the Roth and keep the spouse at 25%," Levine says.
Buying life insurance while you're still healthy is another strategy, James says. The proceeds could provide tax-free income to the survivor. Or he or she can use the money to pay the taxes on future Roth conversions or on the bigger tax bill if the survivor gets bumped to a higher bracket, he says.
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