Losing a spouse changes almost everything about your financial picture. Your income may change. Your spending may change. Your investment strategy may need to change. And, perhaps surprisingly, your tax situation can change significantly as well. One reason is what is commonly called the "widow penalty."
The name can be misleading because there is no special tax penalty for being widowed. Instead, the term describes a situation where a surviving spouse can end up paying more federal income tax on less income after their spouse dies. Understanding this before it happens can create opportunities for tax planning, retirement planning, and decisions about inherited retirement accounts.
How Does the Widow Penalty Happen?
While you are married, you may be able to file your federal income tax return as Married Filing Jointly. That filing status generally provides wider tax brackets than filing as a single taxpayer. After one spouse dies, the surviving spouse may eventually have to file as Single.
This creates a problem:
Your income may not fall by 50%, but your tax brackets can effectively become much narrower.
Consider a simplified example.
A married couple might have $180,000 of taxable income and file jointly. After one spouse dies, the surviving spouse might still have $140,000 of taxable income because of Social Security, pension income, investment income, and retirement account distributions. The surviving spouse now has significantly less income, but may face a higher marginal tax rate on portions of that income because they are filing as a single taxpayer.
And this isn't limited to income taxes.
Medicare Can Be Part of the Problem, Too
Higher income can also affect Medicare premiums through the Income-Related Monthly Adjustment Amount, commonly called IRMAA.
Medicare generally looks at your modified adjusted gross income from two years earlier when determining whether you will pay additional Medicare premiums. That means a large IRA distribution, Roth conversion, or other income event can have consequences beyond your federal income tax bill.
For a surviving spouse, this can create a difficult combination:
One income stream disappears while the tax treatment of the remaining income becomes less favorable.
This is one reason tax planning during the years leading up to retirement can be so important.
Inherited IRAs Add Another Layer
Retirement accounts can become especially important after a spouse dies.
If you inherit a traditional IRA from your spouse, you generally have more options than a non-spouse beneficiary. A surviving spouse may elect to treat the inherited IRA as their own, roll it into their own IRA, or continue treating themselves as the beneficiary. That decision can affect future required minimum distributions and the timing of taxable income.
In other words, the decision about what to do with an inherited IRA is not necessarily just an administrative decision. It can be a tax-planning decision. And once the assets eventually pass to children or other beneficiaries, a different set of rules applies.
What Happens When Your Children Inherit Your IRA?
Under the current rules, many non-spouse beneficiaries are subject to the 10-year rule. Typically, an adult child who inherits an IRA from a parent after 2019 must have the entire account distributed by the end of the 10th year following the owner's death. Depending on the circumstances, annual distributions may also be required during that 10-year period. That can create a significant tax-planning issue.
Imagine a parent dies with a $1 million traditional IRA and leaves it equally to two adult children. Each child receives a $500,000 inherited IRA. They don't necessarily have to withdraw the entire $500,000 immediately. But the account generally must be emptied within the applicable 10-year period, and the timing of those withdrawals can have a major impact on their taxes.
For a child who is already a high-income professional, taking large taxable distributions from an inherited IRA could push additional income into higher tax brackets. That is why the tax consequences of an IRA can extend across multiple generations.
This Is Where Planning Before Death Can Matter
There may be opportunities to reduce the eventual tax burden before an IRA is inherited.
Depending on your circumstances, those might include:
- Roth conversions during lower-income years
- Managing the timing of IRA distributions
- Coordinating retirement withdrawals with Social Security
- Reviewing which spouse owns which retirement assets
- Evaluating charitable giving from retirement accounts
- Reviewing beneficiary designations
- Planning for the eventual 10-year distribution period
- Coordinating investment, tax, and estate planning
None of these strategies are automatically appropriate for everyone.
The important point is that retirement accounts should not be viewed in isolation. The right decision can depend on your current tax bracket, your spouse's income, your children's income, your estate plan, charitable goals, and how long you expect the money to remain invested.
Don't Wait Until Someone Dies to Have the Conversation
One of the most valuable things a family can do is simply make sure everyone understands the plan.
Who are the beneficiaries?
Where are the retirement accounts?
Which accounts are traditional and which are Roth?
What happens to the accounts when the first spouse dies?
What happens when the second spouse dies?
Who is responsible for handling the estate?
And perhaps most importantly:
Does the next generation understand what they are inheriting?
These are not necessarily conversations that need to happen around the dinner table all at once. But they are conversations worth having.
Consider a Family Financial Meeting
For families with significant assets, we often encourage a family or multi-generation meeting. The goal isn't to tell your children exactly what they will inherit or disclose every detail of your finances. Instead, it can be an opportunity to introduce the next generation to the people helping manage the family's financial affairs and explain the general structure of the plan.
For example, a meeting might include:
- Parents or grandparents
- Adult children
- Your financial advisor
- Your CPA
- Your estate planning attorney, when appropriate
It can be as simple as explaining where important documents are located, who to call when something happens, and how the family's retirement and estate plans are generally structured.
Having that conversation before it becomes an emergency can make things much easier for everyone.
The Bigger Picture
The "widow penalty" is a good reminder that financial planning doesn't stop with investment returns. Taxes, retirement accounts, Social Security, Medicare, estate planning, and family wealth are all connected. A decision that makes sense for you today can have very different consequences for your spouse or children years from now. That is why we believe good financial planning should look beyond the individual and, when appropriate, consider the entire family and the next generation.
If you think it would be helpful to bring your children or other family members into the conversation, let us know. We would be happy to help facilitate a family or multi-generation meeting so everyone has a better understanding of the plan and what to expect.
Important Tax and Investment Disclosure
This material is provided for informational and educational purposes only and should not be construed as legal, tax, accounting, or investment advice. The discussion of inherited IRAs, tax brackets, and the so-called "widow's penalty" is intended to illustrate general tax planning concepts and may not apply to every individual's circumstances. Actual tax consequences vary significantly based on individual facts and circumstances.
Tax laws, regulations, and IRS guidance are subject to change and may materially affect the strategies discussed. Any examples, illustrations, or hypothetical scenarios are provided solely for educational purposes and do not represent actual client experiences or guarantee any future tax savings, investment results, or financial outcomes.
Investors should consult with their qualified tax, legal, and accounting professionals before implementing any estate, retirement, tax, or inheritance planning strategy. Investment decisions should not be based solely on tax considerations. All investments involve risk, including the possible loss of principal. The appropriateness of any strategy depends on an investor's specific objectives, financial situation, risk tolerance, and estate planning goals.