In last month’s publication we explored the complications that can arise when a retirement plan is designed for a married couple (filing taxes jointly) suddenly gets turned on its head at the passing of one of the spouses. This month we will examine the real-life challenges from the view point of fictional couple, William and Betty Johnson. We’ll highlight the potential negative financial outcomes of becoming suddenly single for Betty in the late stages of retirement, and strategies that you may be able to implement today to avoid a similar fate. 

Before William’s Passing

William Johnson recently passed away after a 2-year battle with lung cancer. He was 84 years old. He’s survived by his wife of 60 years Betty. They had raised three children together in Ankeny, IA, and were blessed with 10 grandchildren, and two great grandchildren.
 
They had been enjoying their post working years together after William retired from his manufacturing job as a supervisor 21 years ago. They spent much of their early retirement years actively involved in the community. William guided and mentored countless young women locally as head coach of a successful competitive traveling softball team. Betty volunteered much of her time sitting on the board of several local non-profits. They also did a fair amount of traveling throughout the US visiting 41 of the 62 National Parks, and completing two trips internationally chasing down their genealogical ancestry. However, in recent years they’d slowed down and settled into a routine closer to home. 

Johnson’s Finances Before William’s Passing

Their most recent annual income was about $103,000, which was a combination of their Social Security benefits, William’s pension income, and required minimum distributions (RMDs) from their pre-tax retirement accounts.  

At his passing they had accumulated assets consisting of:

William’s gross monthly pension benefit was $1,500 per month with no cost of living adjustment. As pre-tax income it added to their annual tax liability. He had elected a 100% survivor option 21 years ago when he retired. As a result, Betty would be entitled to receive 100% of his pension for as long as she lives if he passed first. 

Because he was the higher wage earner William’s Social Security benefit was substantially greater than Betty’s producing $2,500 per month at the time of his passing. Her benefit was producing $1,000 per month making their combined Social Security income $3,500 each month. 

They were easily able to sustain their lifestyle with an income of about $50,000 per year. Their Social Security and pension income combined to roughly $60,000. This was more than enough to cover their current monthly living expense of $4,114. 

By itself, the combined income from Social Security and Pension would have placed them into a 0% tax bracket with an effect federal tax rate 0% after applying their standard deduction. After calculating their provisional income, less than 9% of their $42,000 annual social security benefits would have been subject to federal tax. However, because their tax footprint was so light, they wouldn’t have needed to worry about paying federal taxes at all.

…But, due to the fact that they are forced to withdraw required minimum distributions from their pretax accounts on an annual basis they were forced into a very different tax reality. 

Approximately $43,000* was forced out of deferment this year. That drove them into the 12% tax bracket, and their effective federal tax rate of just over to 8%. The percentage of their social security benefits subject to federal tax was also impacted. 85% of their combined social security benefits, or $36,241 out of their $42,000 annual benefits, were now taxed at their next highest marginal tax bracket. 

Their Medicare premiums were not affected by the RMDs. They each paid $144.60 because their income fell below the $174,000 limit for married couples filing jointly. If their income ever grew beyond that however, they could be forced into paying increased premiums as a result of the Income Related Monthly Adjustment Amount or IRMAA. 

Lastly, the first $6,300 of qualified dividends and long-term capital gains from their after-tax account would have been subject to the coveted 0% tax rate, and 15% on any above that. 

How and when they received distributions from their retirement and non-retirement accounts would have an impact on their taxes, no doubt. However, as a married couple filing jointly they had greater tax relief potential than is granted to a single filer with similar income. 

*For the purposes of this story I’m ignoring the temporary suspension of Required Minimum Distributions for 2020 under the CARES Act

Suddenly Single at Age 81

After the passing of William, things changed pretty quickly for Betty. The emotional grief of losing her husband of over 61 years is painful enough. However, she’s now experiencing the widow’s tax. Imagine the federal tax system rubbing salt in her still fresh wounds. As a single filer, her tax liability is about to change drastically. 

Her annual income made up of a combination of Williams Social Security benefits which she retained as a survivor benefit, William’s pension income, and her required minimum distributions did decrease slightly from $103,000 to approximately $89,000. On the other hand, her standard tax deduction was reduced by nearly the same amount. Meaning, she’ll have an adjusted gross income similar to what they did as a couple.

Williams pre-tax accounts became Betty’s after he passed. She’s now responsible for taking annual distributions from their combined pre-tax retirement accounts based on factors tied to her attained age.  After a year of moderate accumulation and required distributions Betty’s pre-tax accounts are worth approximately $712,000. Their jointly held after-tax account now becomes Betty’s individual account. It is now worth approximately $210,000, and she still has an emergency fund of $100,000 in a local bank. 

Betty retains Williams pre-tax pension income benefit of $1,500 per month. She also resumes Williams social security benefit of $2,500 per month as a survivor benefit. However, she’ll lose her benefit of $1,000 per month, decreasing the household Social Security benefit from $3,500 to $2,500 per month. 

Like many widows and widowers, the income Betty needs to maintain her lifestyle decreases as a result of Williams passing. With only one person in the house, she won’t be spending the same amount on living expenses. However, it is important to point out that the income she’ll need to maintain her lifestyle as a widow isn’t necessarily get cut in half. That’s not reality. 

Some personally related expenses like food consumption, clothing, personal care, and medical expenses will often be reduced to reflect a single person’s lifestyle. That’s not the case for many other household expenses. Real estate taxes & insurance, utilities, maintenance, and other household level expense don’t automatically decrease to reflect the number of people occupying the dwelling. It’s likely that her widow lifestyle expenditures will be approximately of 80% of the married couple expenditures (80% is what we commonly use in our TWFG retirement planning process).  

Her Social Security benefits and pension income combined to roughly $48,000. This is down from $60,000 while William was alive. Nevertheless, it is still more than enough to cover Betty’s widowed lifestyle. 

However, she is forced to withdraw from her pretax accounts. Now at age 82, she’ll have to withdrawal approximately $42,000 as a result of RMDs. 

The “Widow Penalty”

Betty’s new reality is a combined income driving her into the 22% tax bracket as a single filer. Her effective federal tax rate is just under 13.5%. The percentage of their social security benefits subject to tax doesn’t change. 85% of her benefit is still taxed at the federal level. However, more of it is confiscated due to the higher effective tax rate! 

Her Medicare premiums will now increase from $144.60 to $202.40. Why would her premiums increase just when she becomes a widow? It’s because of her Modified Adjusted Gross Income (MAGI).  Her annual pension income of $18,000 + Social Security benefits of $30,000 + RMDs of $42,000 put her MAGI at $90,000. She is now $3,000 over the $87,000 threshold at which IRMAA begins to apply.

Furthermore, she’s knocking on the doorstep of yet another increase in her premiums. Additional capital gains, dividends, and interest reported on her after-tax accounts, along with any additional distributions from her pre-tax accounts (IRA for example), could easily push her over the next threshold. If her MAGI exceeded $109,000, her premiums could jump again, this time to $289.20. She’s already experienced one increase in her Medicare premium as a result of losing her beloved husband, and not she’s flirting with another hefty increase.

To enjoy a 0% capital gains tax on long-term capital gains and qualified dividends a single filer would need keep her taxable income below $40,000. However, Betty’s way past that. She exceeds the $40,000 threshold with her RMDs alone. Therefore, she’s going to fall within the 15% capital gains tax rate. 

After losing her husband of 61 years Betty is:
•    Thrust into a 22% Marginal Tax bracket (Up from 12%) 
•    Facing an effective federal tax rate over 13% (up from 8% when William was alive)
•    Forced out of a 0% Capital Gains tax rate 
•    Flirting Medicare premiums double those for most folks 

The “Widow’s Penalty” is a term used to describe the negative financial impacts of our current tax and entitlement systems on a retired surviving spouse. 

What could you do today in order to plan to potentially avoid a similar outcome to what Betty is experiencing? 

Fill Up Your Tax Brackets Now

Which tax bracket do you fall into?  How much income would separate you from the next highest tax bracket?  What happens to the unused potential of your current tax bracket if you fail to take advantage of it this year? 

The Tax Cuts and Jobs Act (TCJA) presents a unique opportunity to pay down some of your future tax liability from pre-tax accounts (IRA and 401K) at historically low tax rates. Running through 2025, you still have several years to take advantage. However, any unused bracket capacity this year is forfeited forever. 

Although paying taxes now may seem painful, failing to act may prove to be much more painful later. Considering the recent government spending on economic stimulus compounded on top of an already ballooning federal deficit it is foreseeable that future tax rates will have to increase. It is also foreseeable that the tax base may need to be widened as well. This could result in lowering the progressive tax brackets in order to capture more taxpayer dollars in the upper brackets. 

Strategic Roth Conversions

One productive way to fill up brackets would be to convert some of your forever-taxed money into never-taxed money. IRAs are forever tax, but Roth IRAs are never taxed. Yes, you have to pay taxes on the conversion from an IRA to a Roth IRA, but once converted all growth from there is completely tax free. 

If you have room in your current tax bracket to convert IRA or 401K money to a Roth IRA it may be time to act. It’s foreseeable that converting today under the TCJA could minimize your tax liability, and potentially immunize you from much higher tax rates in the future. 

Roth IRA distributions won’t impact the taxation of Social Security benefits either, and there are no Required Minimum Distributions for the owner of the account. 

If you convert enough of your assets to never-taxed Roth IRA money you could be in a position to better manage your future tax liability, and minimize the Widow’s Penalty.

Imagine if William and Betty would have concentrated an effort to convert all of their pre-tax accounts to Roth IRAs over the previous decades. As a widow, what would it look like if Betty’s $712,000 of IRA money was actually never-taxed Roth IRA money. The percentage of her Social Security benefits subject to tax would have been less than 14% (not 85%). Her next highest marginal tax bracket would have been 10%, and her effective tax rate would be less than 4%. She’d have had over $30,000 of long-term capital gains that could have been realized at a 0% bracket, and she’d no longer be in jeopardy of paying elevated Medicare premiums. 

Pay Down Debt with Pre-tax Money

Another productive way to fill up your tax brackets may be to pay down debt. Do you have credit card debt? How about a financed automobile? Are you planning to pay off your mortgage? You may want to consider using some of your remaining tax bracket capacity to make strategic withdrawals. If you have another $10,000 in your 12% bracket for this year, perhaps you should consider making a withdrawal from your IRA this year to pay off some debt. After January, you could likely do it again without crossing over into the next highest bracket. Of course, if you are under age 59 ½ and make a distribution from your IRA you’ll likely be subject to a stiff 10% penalty for earlier withdrawal. Therefore, this is a strategy best reserved for folks who are older than 59 ½ years of age, and already transitioning in retirement. 

Strategic Asset Location 

How are your investments divided between the various pre-tax, after-tax, and never-taxed accounts that you own?  Where you locate certain assets from a tax perspective may have a significant impact on your future tax liability. 

For example, let’s say that you own stock in an up and coming tech company. The potential for growth is significant. Would you choose to locate this stock in an IRA or a Roth IRA? 

To help you answer that question, perhaps ask yourself this, “Why would I take significant investment risk to aggressively grow my future tax liability?” 

After careful consideration you may come to the conclusion that a Roth IRA may be a better choice. If you are going to take risk in hope of securing a higher rate of return in a growth stock it may be wise to do it in a never-taxed account. 

Meanwhile, if you own lower yielding high grade corporate bonds or US treasuries in your portfolio as a hedge against market risk where might you locate these assets? Perhaps a traditional IRA might make more sense for these assets. You will likely be consuming them first because they are less volatile and tend to experience lower growth potential. 

Conclusion 

William and Betty Johnson enjoyed a successful retirement by most accounts. They maintained a lifestyle without running short on retirement resources. They were able to enjoy their post working years, live a purpose filled life together, and experience financial independence. 

However, their path resulted in a stockpile of pre-tax assets. It all built up to a relatively sharp increase in taxation for the survivor, and it was potentially unnecessary. Had they thought ahead, planned to minimize taxes in retirement rather than postpone taxation as long as possible, Betty’s Widow Penalty may have been minimized or eliminated altogether. 

As you plan for your own transition, from your working years to your post working years, look deep into the future. Ask yourself these questions? 

•    How will the current structure of your retirement assets an income likely playout 20 years from now? 
•    How would rising tax rates and shrinking tax brackets impact your lifestyle? 
•    How would your surviving spouse be impacted based on the current path you’re following? 
•    Are there things you can do today to proactively immunize yourself from future taxes? 
•    What is holding you back from acting and seizing the opportunity? 

If you’re finding it difficult to see into the future, and answer these questions our team at TWFG may be able to help. Use our Purpose and Timeline 5 Step Planning Process, sophisticated financial planning programs, and years of experience as a guide to uncover answers to the questions, and develop strategies that could help your family avoid the Financial Plight of The Retired Widow. 

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