Retirement Answers

Jacob: 00:02

So the negative effects of the widow's tax trap happen because the surviving spouse has to file their taxes as a single filer now instead of a joint filer whenever their spouse was still alive. What this does is it compresses their tax brackets and ultimately makes them pay more in taxes. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If you're someone who's either thinking about retirement or already in retirement, well, you're in the right place. Hey there, my name is Jacob Duke, and each week I'll be walking through different tips and strategies to help you succeed in retirement.

Jacob: 00:38

So let's go ahead and get started with today's show. Hey everybody, and welcome back to Retirement Answers, a podcast built to help you successfully retire. So taxes are often a big concern for retirees, but most people are only worried about the taxes they pay while they're alive. Well, what if I told you that there's a tax trap that's lurking whenever you or a spouse passes away? Well, in today's episode, I wanted to share with you this thing that I call the widow's tax trap and how it could leave your spouse paying way more in taxes after you pass away.

Jacob: 01:11

And be sure to stay to the end because I will be sharing three different strategies to help you avoid this tax trap. So when it comes to planning for retirement, we often hear about all the different tax strategies and how we can do Roth conversions and why we need be tax diversified and asset location, which are all very important things. Actually all of those things factor into this and helping eliminate the widow's tax trap. But one of those biggest tax bombs is whenever a spouse passes away leaving all of their assets and all of their income to their surviving spouse. So how does this widow's tax trap work?

Jacob: 01:41

Well, in short, the widow's tax trap is simply whenever a surviving spouse ends up paying more in taxes than they were paying before their spouse passed away. And what's worse is whenever the surviving spouse is typically making less income. So less income and more taxes, and that is not fun for anybody. Now, are some different ways to help mitigate this tax trap and ultimately avoid it. But before I share those with you, I wanted to break down the different components of the widow's tax trap and how it actually becomes a problem.

Jacob: 02:09

So the negative effects of the widow's tax trap happen because the surviving spouse has to file their taxes as a single filer now instead of a joint filer whenever their spouse was still alive. What this does is it compresses their tax brackets and ultimately makes them pay more in taxes. So in 2023, for example, the top of the 12% tax bracket is $89,450 for joint filers. And for a single filer, is $44,725 So as a single filer, you can only earn half the amount of income to stay in that same 12% tax bracket. But as most people can attest to, your income is not evenly distributed fifty fifty between each spouse.

Jacob: 02:49

One spouse is typically bringing in more income than another in retirement or even before retirement. So one social security might be $3,000 and the other might be 1,800, or one might have a pension and the other might not, or one has large RMDs from their IRAs and the other doesn't. So the tax brackets for a joint filer assume that your relationship is split fifty fifty down the middle from an income standpoint, but we just all understand that real life doesn't happen that way. So back to that social security example that I just mentioned. Let's assume that the deceased spouse was the one that was earning $3,000 a month as their benefit.

Jacob: 03:24

Well, when he passes away, his spouse who is only earning $1,800 on her own benefit now gets to receive her husband's benefit of $3,000 instead of her 1,800. And this is how social security survivor benefits work. The surviving spouse is entitled to 100% of her spouse's benefit or their own, whichever is greater. Now, if we do some quick math, we can see that when she starts receiving that $3,000 a month as her own survivor benefit, that is 62 and a half percent of their total social security benefits of 4,800 before her husband passed away. But her tax brackets are 50% of what they were whenever they filed their taxes jointly.

Jacob: 04:05

So this is an immediate and a hidden tax increase. Now I know that social security taxation is different from normal income and I have different podcasts and resources on that, but you can see the potential issue here. Yes, it's a great thing that the surviving spouse actually gets to take the larger of the two benefits, but because of the compressed tax brackets as a single filer, she will have a higher effective tax rate. So that's what the widow's tax trap is. And in addition to that, she could see that her Medicare premiums are gonna increase as well.

Jacob: 04:32

But how could that happen? Well, IRMAA, which stands for Income Related Monthly Adjusted Amount, is a premium increase on your Medicare Part B and Part D if you earn above certain income thresholds. And in 2023, you can see that for joint filers, are no IRMA penalties until you earn more than $194,000 jointly. At which point your Medicare Part B premiums would jump from $164 a month up to $230 a month. And they continue to increase from there depending on your income level.

Jacob: 05:04

And for a single filer in 2023, the first income level is 97,000. So if you earn more than $97,000 modified adjusted gross income as a single filer, you're gonna have to pay that IRMA penalty. Now it's important to know that there's a two year look back. So those income levels are not what you earned in 2023, they're actually what you earned back in 2021. So if you earned an income in 2021 that was higher than those different levels, that means you would have IRMA penalties here in 2023.

Jacob: 05:34

Now I won't go any further into Irma or Medicare premiums or penalties because that's not what this podcast is about today. I'll have different podcasts come out on that soon, but this is just showing you how the widow's tax trap can increase your taxes, but also create other penalties from a Medicare standpoint. So a couple that is earning $150,000 a year in retirement has no IRMA penalties. One spouse dies and now the surviving spouse is earning $120,000 a year and now they do have IRMA. The surviving spouse's income went down, but they will have to pay higher Medicare Part B premiums simply because they're a single filer.

Jacob: 06:08

And yet this is another example of how that widow's tax trap could be an issue. And the final and perhaps most detrimental component of the widow's tax trap is RMDs. Now let's say that a husband and a wife, they're both 75 and the husband passes away, they have $2,000,000 in their tax deferred IRAs and are making about $80,000 a year, just from RMDs. So they have social security income of $50,000 combined and the wife has a small pension of around $25,000 Their modified adjusted gross income is just under 150,000. So no IRMAA is being assessed to them because they're under those different income levels for a joint filer.

Jacob: 06:46

Now, after the husband passes away, the wife has to continue taking those RMDs of $80,000 and those are gonna be increasing over time along with her pension of $25,000 and the survivor benefit of $3,000 which was what her husband was earning already. So her modified adjusted gross income only dropped to about $135,000 from $150,000 But now that she's filing as a single filer, 30,000 plus dollars of her income will be taxed at that 24% federal tax rate compared to before where none of their income was taxed at that 24% rate. On top of that, she'll be over the IRMA income thresholds causing her to pay higher premiums on her Medicare. And the heart of the issue here is the large tax deferred balances. Those tax deferred accounts come with an expiration date and that expiration date begins whenever RMDs start.

Jacob: 07:36

RMD stands for required minimum distribution. And this means that you'll be forced to take money out of your IRAs or tax deferred employer plans at your required beginning date. Now, right now that required beginning date is either age 73 or age 75, depending on when you were born. The Secure Act 2.0 recently increased those RMD ages from 72 at the beginning of the year. So regardless of when you will have to take money from your pre tax accounts, just know that at some point in the future, whether you want to or not, you will have to take money from those accounts.

Jacob: 08:07

And the issue is that you're gonna have to pay income taxes on that money, which means all that income, whether you want it or not, will be added to your other taxable income pushing you into higher tax brackets. And the worst part is whenever you leave your large IRA to your spouse or perhaps your kids, but specifically in this situation, we're gonna talk about your spouse. They will have to continue taking those RMDs, but now they've gotta pay taxes on that as a single filer. So the income remains the same, but the tax brackets are cut in half, resulting in a higher effective tax rate and ultimately a higher tax bill. So that can be quite defeating, but there are some things that you can do to proactively help and mitigate against that widow's tax trap.

Jacob: 08:45

The key is that you have to start by planning ahead. So here are three ways that help eliminate the risk of that widow's tax trap. The first way is to start early. If you're still working and saving for retirement, you still have a chance to build tax diversification into your portfolio. And what I mean by this is having savings in three different tax buckets.

Jacob: 09:02

You have tax free, tax deferred and taxable. So that would be your Roth IRAs or 401ks, your traditional IRAs or traditional 401ks, and also that normal brokerage account. When you have money saved in each of these different tax types, you are mitigating that tax risk in retirement because you will have optionality and flexibility on when and where you pull your income from. So the opposite of this is whenever you have all of your retirement savings in your pre tax four zero one ks, and your only choice is to pull income from that account in retirement, which will be taxed as normal income. So I talk about this often, but if you're still working, you should have a strategy on where you're saving.

Jacob: 09:39

Yes, how much you're saving really does matter, but your intentionality behind where you're saving will create less tax headaches in the future. So the second way to help mitigate the risk of the widow's tax trap is by doing Roth conversions. Now, it's important to plan out your conversions because it only makes sense to do those is when your income is lower than either it has been in the past or it will be in the future. Think of the best time to do these Roth conversions as a gap in your high income years. So I like to call this your gap years, and these are typically in the early stages of your retirement.

Jacob: 10:10

So you aren't working and earning a high income anymore and RMDs have not started yet, so there's this period of time whenever your taxable income will be lower. That's probably when you're gonna wanna do those Roth conversions. Now, a few other things have to happen for Roth conversions to actually be beneficial. The first thing is you need to have after tax money to pay the taxes with. This could be cash that's at your bank account or it could be investments in that taxable investment account that I like to talk about.

Jacob: 10:35

But regardless, it's almost always best to pay those taxes on the Roth conversions with cash instead of having those taxes withheld from the conversion amount. If you wanna learn more about how to pay taxes on Roth conversions, be sure to subscribe because I've got a podcast coming out very soon about how to do that effectively. Also, another important component to a successful Roth conversion strategy is to keep your income as low as possible. Now that could mean delaying social security beyond 62 and minimizing your otherwise taxable income like IRA distributions when possible, or perhaps delaying other sources of income. The idea is to pay less on your tax deferred dollars now by doing the conversion compared to what you otherwise would pay in the future.

Jacob: 11:14

So by doing those conversions, you're lowering your pre tax account balances, thus lowering your RMDs, which ultimately will help you avoid the widow's tax trap. And the final way to help avoid that tax trap is by spending down your IRAs earlier in retirement. If you don't plan on doing Roth conversions, then maybe pulling money from your pre tax accounts to live on will help you draw down those account balances before you get to RMD age. This will help your surviving spouse not have too high of RMDs, which will ultimately avoid triggering the onslaught of increased taxes and those increased Medicare premiums. So creating a thoughtful income strategy in terms of where you're gonna be pulling money from and when you're gonna be pulling it could pay off big time throughout your retirement.

Jacob: 11:53

So that taxable investment account and those brokerage accounts, they receive a step up in basis and they don't have RMDs, your Roth IRAs and your Roth 401ks beginning in 2024, those will also not have RMDs. So those accounts might need to be left alone so that you can draw down those tax deferred balances first. So I know this has been, just a lot of information around perhaps a new concept, but ultimately getting money out of the tax deferred status into the tax free status in the Roth will help you limit those future tax bills for your spouse after you pass away. So let's go ahead and answer this week's question. So this is a question about life insurance and whether or not it's necessary in retirement.

Jacob: 12:33

And it reads, hey, I've got $750,000 of a term life policy that is about to expire in two years. I'm 63 and I'm married. I've got three kids who are all grown. My wife and I, have enough for a good retirement, but for some reason I feel uneasy about letting my life insurance expire without getting another policy. Should I let this policy lapse or should I get a new policy to replace it?

Jacob: 12:55

So this is a common question that I get a lot because many people who are entering retirement age have had a term policy their entire career, and when retirement rolls around, those policies are getting close to expiration. And to be honest, that's a great thing, right? That means that you've survived and outlived your life insurance policy. So congrats to you. But what would I suggest in this type of situation?

Jacob: 13:14

Well, as a quick reminder, life insurance is designed to replace your income when others either currently or in the future will depend on your income. So by the time most people reach retirement age though, retirement is only kind of an option because they don't have anyone that's depending on them other than perhaps a spouse. So with that said, you likely wouldn't need to get a new policy to replace the one that's gonna be expiring in a couple of years. And given that you mentioned you have adequate savings for retirement, if you passed away today, your wife should be well taken care of without the need of a life insurance policy. The hard part about getting life insurance later in life is that your premiums would be pretty high because of your age or other health issues that either are currently going on in your life or have previously gone on.

Jacob: 13:55

And because of this, it may not make sense to get a new life policy, especially if you're gonna get like a whole life policy, those premiums are gonna be really, really high. But some people like to use life insurance as a tax free gift to kids or grandkids, so depending on your situation and what you're trying to accomplish, it may make sense for you. But in general, being what's called self insured is typically the best option when it comes to life insurance and retirement. Most of the time, it doesn't make sense to get a new policy with those really high premiums. So I hope this helps you answer your question around letting the policy either expire or get a new one in a couple of years.

Jacob: 14:27

If you've got a question, be sure to send that in to me. That way I can answer it right here on the show. Thanks so much for tuning in to this week's episode of Retirement Answers. We'll talk again soon. Hey, it's Jacob again, and I wanted to extend a quick offer to you.

Jacob: 14:41

If you have a question and you would like to have it answered here on the show, please email me at jacobretirementanswers dot net. And I'd love to answer that question for you right here on the show. Also, wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode.

Jacob: 15:02

I look forward to talking with you again next week.