Money Talk: Retirement tax planning must account for widow’s penalty

Tax planning when saving for retirement differs significantly from when the focus turns to spending down a retirement nest egg. When saving, especially during one’s peak earning years, deferring as much taxable income as possible into a retirement plan in order to reduce current taxes often takes priority. This makes perfect sense when the expectation is that cash flow needs in retirement will be lower, requiring a smaller amount of taxable income. The simple rule is, if you expect to be in a lower tax bracket during retirement, save on a pre-tax basis today. When the opposite is true (lower tax bracket today), save on an after-tax basis by making Roth IRA or 401(k) contributions.

Because there is a significant difference in the tax bracket and standard deduction amounts for single and married taxpayers, couples heading into retirement should account for the high likelihood that one of them will finish their retirement as a single tax filer since it is unlikely that they will die in the same year. The tax brackets for single tax filers start at about half of the income limits that apply to married filers, except at the highest tax brackets, and single filers receive a 50 percent smaller standard deduction.

This tax bracket structure means that a retiree who loses their spouse and does not remarry will have a significantly higher tax burden because their income may not drop much, even if they do not need it. Those collecting Social Security retirement benefits will see that income stream drop as only the higher of the two payments will continue after one spouse’s death. Retirees with pension income may also see a decline in income if the pension had less than a 100% spousal continuation benefit. Both of these factors will tend to keep a surviving spouse in a lower tax bracket but for the fact that their standard deduction is much smaller. When you factor in required minimum distributions from pre-tax retirement accounts however, income is unlikely to go down if the surviving spouse is the beneficiary of these accounts. These distributions will only be smaller if the surviving spouse is younger than the deceased spouse since he or she can use their own life expectancy to determine the amount of the future required withdrawals.

The higher tax burden faced by widowed retirees is commonly referred to as the widow’s penalty. This penalty is compounded by the fact that Medicare premiums go up with income. Consider a couple whose Social Security income, interest, dividends, and Required Minimum Distributions put their income at $200,000. Their taxable income would sit in the 22% tax bracket, and they would not face additional Medicare premiums due to the Income Related Monthly Adjustment Amount (IRMAA). If filing as a single taxpayer, their taxable income would jump to the 24% tax bracket, and they would pay an extra $5,000 for their Medicare premiums.

Avoiding these negative tax consequences requires an acknowledgement of one’s mortality and some long-range cash flow forecasts based on one’s particular financial goals. Such projections should be part of any long-term financial plan that no one should enter retirement without. These projections will provide an estimate of portfolio values, income and RMD amounts based on specific lifestyle-based financial goals. When expected tax brackets jump significantly in retirement, it may make sense to accelerate income into years when a couple can make maximum use of the joint tax brackets.

Often, pulling future income back to the current tax year takes the form of Roth conversions. Executing small Roth conversions annually when approaching retirement, waiting to start Social Security benefits, or waiting to hit RMD age (now age 73) can go a long way toward reducing future RMDs and help reduce the amount of a surviving spouse’s taxable income that will land in the higher tax brackets. These conversions, however, should keep the IRMAA thresholds in mind so that the tax picture accounts for all of the costs of a Roth conversion.

Capital gains are another source of income that a taxpayer might consider bringing forward to the present, particularly in the year one spouse dies. Since this is the last hear a joint return can be filed, selling appreciated assets that did not receive a basis step-up on the first spouse’s death may be beneficially, but likely less so than a Roth conversion.

David T. Mayes is a CERTIFIED FINANCIAL PLANNER ^TM professional and IRS Enrolled Three Bearings Fiduciary Advisors, Inc., a fee-only advisory firm in Hampton. He can be reached at (603) 926-1775 or david@threebearings.com .

This article originally appeared on Portsmouth Herald: Money Talk: Retirement tax planning must account for widow’s penalty