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The Widow's Tax Trap: What Is It & How To Avoid It · Retirement Answers

• 0:00
  Jacob: Hey, friends, and welcome back to another episode of Retirement Answers. My name is Jacob Duke. I'm your host, as always. I'm also a certified financial planner and own a retirement planning firm where we help people just like you plan smarter so you can retire better. So today on the show, want to talk about something called the widow's tax trap.
• 0:16
  I've actually done an episode on this previously, but wanted to retouch on this because there's so many new listeners, and I want everyone to know about it because if you are married, this could be an issue for you in the future. If you're not aware of it, it could become a big deal. And I want you to know why this is, how it creates maybe other phantom income taxes that you might not know about, and how to eliminate or mitigate this risk. So I want give you some ideas on what you can do to be proactive here. So first of all, what is the widow's tax trap?
• 0:42
  Well, in essence, or I guess in short, what it is whenever one spouse passes away, leaving assets to the surviving spouse and that surviving spouse will then have to pay a higher tax rate on any income or IRA distributions or pension or Social Security that's out there that's coming to them. They're gonna have to pay a higher tax rate because the single tax filer rates are half of that of a married filing jointly. So just because someone passes away, and now has to file as a single filer moving forward, that means that their tax rate at the marginal level is going to be higher, their effective tax rate obviously would be jumping up as well. So that's the issue. But who is this a big issue for?
• 1:18
  Really, it's for married couples who have a high amount or a large balance of tax deferred assets, things like IRAs or 401ks or 403Bs because they've done all their saving throughout their career, and they've accumulated a high amount of tax deferred assets because their income was so high while they were working or they shouldn't notice saving in other way. And so they saved everything into a tax deferred account. So the key there is whenever you have these different accounts, you will eventually get to what's called your required beginning date. This is whenever you have to begin taking distributions through what's called an required minimum distribution. So you have to take money out once you reach a certain age and in 2025 under the Secure Act 2.0, these ages are 73 or 75, depending on when your year of birth is.
• 2:03
  So if you're born before 1960, then your required beginning date, the age in which you have to take these distributions and start doing that is 73. If you were born 1960 or after, your required beginning date is '75. So, there's a difference there in your age that you have to take money out of these accounts depending on the year in which you were born. Now, the reason that this is a big deal and this comes up later on in life, especially once one of you passes away, if you are married, is because typically whenever one spouse passes away, the other spouse is either already in their RMDs or is going be starting them fairly soon. So for example, if you have a couple with $500,000 in one IRA for the husband, and then the wife has $500,000 in her IRA, in total, they have a million dollars.
• 2:47
  And if we just assume that they're the same age, they're gonna start their RMDs in the same year. And so what you've got there is a million dollars that has to have RMDs taken on it beginning in that year. Now, if we flip and go forward and say one of those spouses, let's say the husband in this situation passes away, and then the wife she inherits or assumes that 500,000 from him is her own, either way, she still has now a million dollars that has to have RMDs taken from it regardless of if she owns it just herself now that she's a widow, or if they were both still living and still had to take these RMDs on that million dollars, the dollar amount that they have to take is based on how much money is in the accounts. And so the dollar amount taken is gonna be the same whether he's alive or not, but the key is is her tax rates, if he passes away, she'll be filing as a single tax filer and that's whenever her tax rates will get compressed. And so the dollar amount that has to be distributed out is gonna stay the same, but her tax brackets are a lot smaller.
• 3:41
  And so then she's gonna have more taxes at those higher levels because the income is still the same amount that she has to pull. So that's a quick summary of what the widow's tax wrap is. And hopefully that makes sense and how this could be an issue. So for example, if your RMD in year one is $50,000 married filing jointly, and then the husband passes away, and then RMD in year two, it's certainly 50,000 or whatever the new amount is could be potentially higher depending on how much the account has grown. The wife that's surviving now has to take that full 50 plus thousand dollars out of the account to meet those RMD requirements.
• 4:13
  But again, her tax brackets are compressed. Now that's the first issue is a higher tax rate on those distributions. That's pretty easy to kind of understand. But what a lot of people don't consider or factor in is something that you could call phantom taxes or hidden taxes or extra gotchas that are there. And this can include things like higher taxation of Social Security benefits, but also perhaps even forced IRMAA surcharges because again, your income could be too high.
• 4:38
  So how about we walk through an example of how this could play out for, you know, just to show you how the Social Security taxation might end up being an issue if this ends up happening. Alright, so let's assume that we've got a married couple, we're going to call them Bob and Susie. And so they're both collecting $3,000 a month. They're both 75 years old. So they're both already taking their RMDs or this will be the first year that they have to do that.
• 5:02
  So they're getting $3,000 a month each in Social Security for a total of $72,000 per year. Now, let's say this that they also have about a million bucks in tax deferred accounts. So their first year RMD would be close to $40,000 give or take a little bit. I want to keep the numbers round here to make it really simple for us rather than making it complicated. So $40,000 is their first year RMD out of their IRAs plus their $72,000 in social security.
• 5:27
  So that makes their total income about a $112,000 per year. Now, when it comes to this, we know that one twelve is how much they're actually getting, but out of their social security amount, I've talked about this a bunch, but how much of your social security is taxable depends on your other sources of income. And in fact, you could have anywhere from none of your Social Security benefits being taxable all the way up to 85% of your benefits being subject to taxation. And I've talked about Social Security taxation many times in the past. I've done episodes here on the podcast where I explain how the calculation works to determine how much of your benefits are subject to taxation, but you have to find something called your provisional income and figure out from that how much of your benefits are subject to taxation.
• 6:07
  I'm not gonna go through that here, and all what I'll do is I'll have the the episode linked below and maybe a YouTube video as well since I've got more details there on that that you can watch visually to show you how this calculation works to determine your Social Security benefits and how much would be taxable. So I'm not gonna explain it here today, but just know it's not quite as simple as most people realize. So for this example, I've already done the calculation on this to kind of save us some time here, but out of their $72,000, assuming this $40,000 RMD on top of that, only 46% of that 72,000 is actually going to be subject to taxation. So this means that only $33,200 is going to be taxable out of their benefits. So 33,200 plus the $40,000 of their IRA distribution because of the RMD, that's their new what's called AGI adjusted gross income.
• 6:54
  So 73,000 and change how much they're actually going to be putting on their return. Now, here's the thing, I'm not including new legislation under the one big beautiful bill that's now in place where we've got the extra $6,000 per person bonus deduction for seniors because again, their modified adjusted gross income is above that $75,000 threshold. But the thing is, I want to keep it all super simple. And so they could get a portion of the $6,000 bonus deduction for seniors, but I'm not going to do the math here and and make it really complicated. I want to keep it simple.
• 7:25
  And since we're comparing apples to apples, and we're not adding in an extra deduction here or in the future spot in this example, it kind of doesn't matter. So only 46% of their benefits are going to be subject to taxation. Now, let's see how much of Susie's benefits would actually be taxable after Bob passes away. So let's say that Susie's going to get her same benefit of $3,000 a month. So that's gonna be $36,000 per year that she's now getting because since he passed away, since her benefit and his were the exact same in this scenario, then she's not getting a survivor benefit that will be higher than her own benefits.
• 7:56
  So that has to be factored in in your situation once you get to this point. But because they still have a million dollars, whether she assumes that million dollars as her own or just simply has an inherited IRA, she still has to take an RMD out of the accounts. Okay, and so let's assume that the RMD is still $40,000 next year after Bob passes away. Well, if she's filing as a single filer now, her total income will be $76,000, 3,000 a month from Social Security, $40,000 RMD. So $76,000 is now how much she is getting as an individual person as a single tax filer towards before she was getting a 112,000, which the difference there is just simply Bob's social security amount.
• 8:34
  So she's getting $76,000 between social security and this RMD as total income. And again, I've already done the calculation here, but whenever we do the math on this, 85% of Susie's Social Security benefits are now going to be subject to taxation. This comes out to about $30,600 of her benefits that are going be taxable. So do you see what's happening here? So before only 46% of both of their benefits combined was actually subject to taxation.
• 9:02
  Remember that was what 33,200 of their 72,000 of benefits. And now Susie's only getting $36,000 of Social Security benefits, but 85% of that amount is subject to taxation, which brings that total to 30,600. So now she's getting half of the Social Security benefit amount from 72 to 36 now that Bob's not here, but almost the same amount is actually going to be taxed. Before remember it was only 33,200 and now it's 30,600. So only a $2,600 difference in total benefits being taxed, but she's not getting near as much.
• 9:39
  She's only getting half of what they were before whenever he was alive. So that right there is what I call a phantom tax, an additional gotcha that kind of pops up whenever the widow's tax trap happens. Yes, her marginal tax rates are going up because the brackets are now compressed, but also more of her social security benefits in total are being taxed as well. So that's one element of this. The other element is IRMAA, which stands for income related monthly adjustment amount, and this applies to your Medicare premium.
• 10:06
  So if you earn too much money, you could pay a higher premium on your Medicare insurance. And so again, this is what these RMDs, required minimum distributions, can do in terms of total taxes being paid and increasing your rate as you age and get older and go throughout retirement. They could definitely hurt you while you're still married, but the big deal is whenever one spouse passes away and now you have to pay more tax on even higher amounts of distributions because they're being forced for the rest of your life. So this cascading of additional taxes becomes something that you can't avoid once you get there. So that's why I wanna tell you how you can maybe mitigate the risk or eliminate parts of these issues early on in retirement through proper planning.
• 10:44
  Now I wanna give you three solutions that you could either pair together or kinda combine approaches on, but I wanna give you three things. The first one you might be thinking in your mind, oh, Jacob, this is really obvious. I need to do Roth conversions, and that might be correct. Roth conversions are a way to help reduce your total tax deferred account balances, which in turn reduces how much your RMDs would be in the future. That's the ultimate goal of a Roth conversion.
• 11:06
  Now here's what I'll say. Just because you can do a Roth conversion today doesn't mean that you always should. The point of a Roth conversion is to pay taxes at today's tax rates that would be lower than whatever they would be in the future. Now we're kind of playing with a little bit of assumption whenever we do this because we're assuming one of two things. We're assuming that our income will be so high in the future that we will be pushed into a higher marginal tax bracket.
• 11:31
  Think of maybe going from, hey. Today, we'd cap out at paying 12% on any dollar at the marginal tax rate, or in the future, it looks like our income might be so high between a pension or Social Security and maybe our RMDs, it would be actually paid at 22% using today's levels and today's rates. So you could assume, oh, our tax rates in the future would be higher because 22% is definitely higher than 12. Now that's one way of thinking about it. The other way is saying, hey.
• 11:56
  Today, we're at fairly low tax rates, at least at a historical level. Our tax rates today are really good. We've got ten, twelve, 22, 24, and so forth, and those are really low historically. Now some would make the argument that tax rates can only go up up from here. Now I have no idea what's gonna happen.
• 12:13
  Obviously, none of us do, but it would be safer to say that tax rates have to go up at least a little bit rather than go down over the next ten, fifteen, twenty, thirty years. So whether or not you should do Roth conversions only makes sense if your tax rates today are gonna be lower than whatever your tax rates would be in the future. This means that you probably don't need to do conversions. If you're still working, making a bunch of money in the last couple years of your career, it's probably easier just to defer your savings into your four zero one k on the tax deferred side, don't do any conversions, and then be able to take money out at a cheaper tax rate just through a distribution or through conversions once you are retired and your income drops off. So again, by doing these conversions, you can reduce your total tax deferred balances moving forward.
• 12:53
  Now, the second thing that I want to mention here is that you could do instead of conversions, you could do just a simple spend down strategy. So you're intentionally spending your IRAs, your tax deferred money, before any other sources so that you can, again, reduce how much money you have in those account balances, and you know that the tax rate you pay today on those distributions will, again, be lower or the same compared to whatever you'd pay in the future. So the idea here is, example, We got a million bucks in tax deferred IRAs. Maybe we got a 100 or $200,000 in Roth and brokerage kinda combined. So we have the option to pull money from brokerage, which is the normal starting place.
• 13:29
  Hey. Take all your money out of your brokerage account first. We could take money from Roth, but typically, you wanna delay that if you can. I've got different thoughts on that that I've shared in different episodes. So in this scenario, I would say, hey.
• 13:40
  If if RMDs are are potentially gonna be an issue in the future, we can project that forward, see you know, maybe our anticipated growth rate on this account would be. And so a million dollars could be upwards of $2,000,000 by RMD age if we're not careful. So the thought here is what if I just spend more of my IRA than my other account types that don't have RMDs? What if I spend more of this account type so that we can kinda control how much our account grows over time, but also maybe spend it down intentionally and just avoid Roth conversions altogether, then it might make sense to do that. So that's number two is a spend down strategy in replacement of a Roth conversion strategy, and maybe there's room for both of those.
• 14:18
  Typically, it's gonna be hard to do both of those in the same tax year because, again, if you're spending money out of an IRA by taking distributions, you're using up those lowest tax brackets, which maybe defeats the purpose of even doing a Roth conversion. Again, you've got to look at all this yourself, run the projections, see what it all shows, and kind of how your situation plays into this. But the third thing I wanted to tell you to help reduce or lower how much money you have in tax deferred accounts is to simply invest your IRAs in a more conservative manner than maybe your other account types if you have them. So if you've got a Roth, if you've a brokerage, and you're not actively spending or using money out of those accounts, have those invested aggressively so they have the most potential to grow. Now your IRAs, you might want to intentionally limit the growth opportunities in it so, again, you don't just grow this huge RMD and big tax bill for yourself in the future when otherwise you wouldn't need that income.
• 15:11
  Now I'm not saying, hey. Don't go make money in your accounts. That's not what I'm saying. A lot of people hear this and say, Jacob, why would I not wanna make money whenever I can make money and then I have more money to pay the taxes with? I totally get it.
• 15:21
  You want to have as much money as possible and invest with a purpose. But here's the thing. What I'm really talking about is asset locations. So if you've a million and $0.5 and you know you need to have a 70% stock, 30% bond portfolio to kinda meet your risk profile and kind of your income needs out of the portfolio, it wouldn't make sense to have $70.30 in each of these different account types, traditional Roth and brokerage. You wouldn't want to have that evenly dispersed across each account type because it doesn't use the advantage of the account type in the proper way.
• 15:50
  For example, a Roth, that's gonna be a tax free income source in the future. So you wanna have that one invested as aggressively as possible so you can have as much tax free growth as you can. Your brokerage account, that's gonna be taxed every single year. So any normal interest that would be generated from fixed income like bonds, CDs, or or money market, that's gonna be taxed as a normal income every single year. So to lower your taxes every year, you could reduce how much interest you're generating and instead invest the money in stocks or equities that create long term capital gains when you hold an investment for longer than a year.
• 16:22
  But then also, two, you could have qualified dividends from those stock holdings as well. So your overall tax rate annually, number one, is gonna be going down because of the type of income that could come into the account. But then also two, stocks generally create less income than fixed income like CDs and again, corporate bonds and treasuries and things like that. So investing your brokerage account in this way is thoughtful from a tax perspective, and then finally, your tax deferred account. Again, if you don't want to create a large tax bill for yourself in the future, then reducing or limiting how much growth you have there is a big deal, but then also it helps you lower your tax bill every year to hold any bond or fixed income or money market positions that you know you've got to have in your portfolio from a risk standpoint, hold that in your IRA because, again, that's a tax sheltered account, meaning you can have as much interest generated by your holdings every single year, and you're not gonna pay taxes in that year.
• 17:13
  You only pay taxes on an IRA or a four zero one k or a four zero three b whenever you distribute the money out of the account, and every single time, it's gonna be taxed as normal income. So when you think about asset location, how that could help you reduce this issue of the widow's tax trap because you're reducing your potential RMDs by controlling the amount of growth within your tax deferred accounts, that's just another element or layer to this whole thing and trying to mitigate the risk that the widow's tax trap can present. And so hopefully, these ideas around the widow's tax trap and some of the strategies and ways that you can reduce the issue, reduce that potential problem, get you some ideas for how you can apply this to your situation. Because I don't want you to just take this and say, Jacob said to do wrong conversions, Jacob said to do spend down, Jacob said to do this or that. What I wanna do is always present ideas and thoughts and say, how do you use this in your situation?
• 18:03
  Because here's the thing, not all these strategies work for everyone. You gotta analyze it for you. And if you'd like help analyzing your situation and seeing what the best fit is for these different strategies, I'm happy to have a conversation with you. You can book that using the link down in the description below. We'll have a free, no obligation call.
• 18:18
  We get to know each other, hear more about your situation, and just see if there's anything that I or my team can do to help. Alright. Thank you so much for tuning in to this week's episode of Retirement Answers. I will talk to you again next week.