The common wisdom in the financial community is not to make any major decisions regarding investments for at least a few months after the loss of a spouse. There are clear issues that need be thought through on the investment arena as the tax issues move on their own clock.
What is rarely addressed after the passing of a loved one is the widow or widower penalty where two individuals were filing a joint tax return and suddenly one of them has passed. The U.S. federal 1040 tax return is considered a progressive tax system where the more income you recognize (earned income, interest, dividends, business, rental, required minimum distribution, etc.) the higher your marginal tax rate. We all start on the first step with some of our income being taxed at 10%, then 12%, 22% with various steps in between up to 37% as the maximum.
The question is “how much income can you recognize and be taxed at the lower brackets?” The answer is based on how you file! Most of us as married couples file a joint return. After the standard deduction is subtracted (or itemized if your deductions are greater than the standard allotment) a married couple can earn approximately $101,000 a year and have the first $19,050 taxed at 10% and the next $58,349 taxed at 12%. The very next dollar of earned income would be taxed at 22% at the federal level.
When bad things happen, your tax return can turn very ugly. When a spouse passes away you have until the end of that tax year to file one more time as “married filing jointly.” That is true whether they pass away in January or December, what matters is the calendar year and there are issues that simply cannot wait to be discussed.
We have witnessed surviving spouses pay as much as 50% more in federal taxes the following year simply because they lost their partner. That seems like throwing more fuel on an already distressed situation and it is. Here is how it works:
The Internal Revenue Service reports that 70% of the money in tax-deferred retirement accounts including IRA’s are not accessed until individuals are forced to take required minimum distributions (RMD’s). Each year a larger percentage is required to be distributed. When a person passes away, the remaining spouse is no longer filing a joint return after that calendar year and yet they still typically inherit all the retirement assets. Now the first $9,525 is taxed at 10% and the next $29,174 is taxed at 12%. Suddenly, their tax bracket jumps to the 22% after that and possibly even higher.
In the days of pensions this phenomenon was less important, but it impacts more families today which requires proper planning all that more important. The RMD’s required from very large retirement accounts and IRA’s create serious challenges for surviving spouses. We call it marginal tax rate compression and the impacts are real. If you lost a loved one in 2018, please get tax advice this year, not after December 31st, when it’d be too late.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see our Disclosure page for the full disclaimer.