Most of the time when we do income tax planning it’s motivated by one or more transactions that have occurred or may occur in the current year. A common example would be the proposed sale of a rental property. Depending upon the particular facts, the sale could trigger income tax liability or savings, the latter occurring when there are passive loss carryovers. Either way, preparation of an income tax projection to determine the appropriate course of action given one’s financial situation and financial goals would be prudent.
Rarely do we look ahead and do income tax planning for multiple years. In addition, married couples, especially those who are young and in good health, don’t like to think about, let alone plan for, the possibility of losing their spouse.
Married vs. Surviving Spouse Example
Unfortunately, the income tax law isn’t kind to surviving spouses who don’t remarry. A widow or widower who has the same, or even less, income than the couple enjoyed will often be subject to higher federal, and potentially, state, income tax liability. The best way to illustrate this is with an example.
Let’s assume that John and Susan, who live in California, have the following income that they will report on their 2019 income tax returns:
- Qualified dividends – $5,000
- Rental property net income – $40,000
- John’s Social Security – $20,000
- Susan’s Social Security – $40,000
- Traditional IRA required minimum distributions – $56,000
- Fixed income annuity income distribution – $24,000
Let’s also assume that John and Susan’s standard deduction, the amount of which is $27,000, exceeds their total itemized deductions. After excluding 15%, or $9,000, of their Social Security benefits from taxation, John and Susan’s taxable income is $149,000. Their federal and California income tax liability is $24,200 and $4,300, respectively, for a total of $28,500.
Suppose instead that John died in 2018 and Susan hadn’t remarried as of the end of 2019. No matter which day John’s death occurred, Susan would have been allowed to use married filing joint status for 2018.
Assume that all income items are unchanged in 2019 with the exception of John’s Social Security of $20,000 which is eliminated. This would result in a reduction in total income of $17,000 after the 15% Social Security exclusion. As an aside, the exclusion can be as much as 100% depending upon one’s other income.
As a surviving spouse, Susan will be subject to several widow penalties that will result in greater 2019 federal and California income tax liability than would have been the case had John not died in 2018. The first penalty that Susan encounters is a 49% reduction in the standard deduction she can claim, going from $27,000 if John was still alive to $13,850. This results in taxable income of $145,150 for Susan.
Even though Susan’s taxable income is $3,850 less than John and Susan’s taxable income of $149,000, Susan is hit with widow penalty #2, i.e., increased marginal federal tax rate. This is now 24% vs. 22% when Susan was married. This increases her federal income tax liability by $4,400, or 18%, going from $24,200 to $28,600.
The state of California is also unsympathetic toward widows and widowers. Although Susan’s California adjusted gross income of $125,000 is identical to when she was married due to the fact that California doesn’t tax Social Security benefits, she is subject to three penalties as a single taxpayer:
- 50% reduction in allowable standard deduction, decreasing from $8,802 to $4,401
- Higher effective tax rate of 7% vs. 4.6%
- 50% reduction in personal exemption credit
The foregoing penalties increase Susan’s California income tax liability by $3,700, or 86%, going from $4,300 when she was married to $8,000. Susan’s total 2019 income tax liability is $36,600 which is $8,100, or 28.4%, greater than John and Susan’s 2019 income tax liability of $28,500.
Income Tax Planning Opportunity
Surviving spouses, especially older ones, often don’t remarry. This needs to be considered in income tax plans knowing that widow(er) penalties often result in increased income tax liability. This approach also dovetails with the retirement income planning goal of optimizing after-tax retirement income to cover projected expenses and prolong the life of investment assets.
The use of income acceleration strategies increases in importance when you combine widow(er) penalties with the window of opportunity offered by the Tax Cuts and Jobs Act of 2017. The wider income tax brackets and lower income tax rates that went into effect in 2018 end in 2025. Many income tax professionals, including myself, are of the opinion that income tax rates will increase in 2026 given the multiple financial and associated budget challenges we face as a country.
Timely Roth IRA conversions are at the top of my list of income acceleration strategies for clients who understand that it can make sense to prepay income tax in order to increase longevity of investment assets. There are two types of timely Roth IRA conversions: strategic and market-sensitive.
Strategic conversions take advantage of opportunities to minimize income tax liability associated with the conversion, e.g., a rental property suspended loss. Market-sensitive conversions take advantage of sizable stock market declines without attempting to time the market.
The goal of Roth IRA conversions is to optimize lifetime after-tax distributions. Strategic and market-sensitive Roth IRA conversions can accomplish this in four ways:
- Elimination of income tax on appreciation of Roth IRA accounts
- Reduction of required minimum distributions (RMDs) and associated income tax liability to the extent that funds have been transferred from tax-deferred non-Roth qualified retirement plans and traditional IRA accounts to nontaxable Roth IRA accounts
- Potential reduction of taxable Social Security benefits as a result of reduced RMDs subject to amount of other income
- Potential reduction of Medicare Part B premiums as a result of reduced RMDs and modified adjusted gross income
Elimination of income tax on appreciation of Roth IRA accounts and reduction of RMDs and associated income tax liability can potentially reduce widow(er) penalties. If you’re married and are hesitant about prepaying income tax in connection with a proposed Roth IRA conversion, think about the increased income tax liability your widow(er) may incur.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.