Married Couples Face a Tax Trap When One Spouse Dies. Here’s the Fix

Married couples plan their retirement as a pair. The tax code does not. The year after one spouse dies, the survivor files as a single person, and almost everything about the return gets worse at once: the standard deduction is cut in half, the extra deduction for being over 65 is cut in half, the new $6,000 senior deduction is cut in half, the brackets compress, and more of Social Security becomes taxable. The income does not fall nearly as much as the deductions do.

Advisors call it the widow’s penalty, though it hits widowers the same way. It is predictable, it is large, and the fix only works while both spouses are alive. Here is what it looks like for a couple who are 68 today with $1.2 million in traditional IRAs.

The couple’s return today

They are both retired. He collects $3,200 a month from Social Security, she collects $1,900, which is $61,200 a year between them. They draw 4% from the IRAs, $48,000, and the rest of the accounts sit in an S&P 500 fund and Treasuries.

On a joint return, the Social Security worksheet counts their $48,000 of other income plus half their benefits, $78,600 in all, against the $44,000 line for couples. The result is that $35,410 of their $61,200 in benefits is taxable. Adjusted gross income is $83,410.

Then the deductions. A couple gets a $32,200 standard deduction, $1,650 each for being over 65, and $6,000 each from the senior deduction that runs through 2028. That is $47,500 off the top. Taxable income is $35,910, every dollar of it in the 10% and 12% brackets. Federal tax: about $3,800 on $109,000 of cash coming in.

The survivor’s return

Now he dies. She keeps the house, the IRAs, which she inherits and rolls into her own name, and the larger Social Security check. Her own $1,900 benefit stops, so her Social Security income is $38,400 a year, down from $61,200.

Her expenses do not drop by a third. Property tax, insurance, the car, the utilities are what they were. She keeps drawing the same $48,000 from the IRA.

For the year he dies she can still file jointly. Starting the next year she files as single, unless she has a dependent child at home, which at 68 she does not. Here is that first single return.

The Social Security worksheet now uses the single thresholds, $25,000 and $34,000. Her $48,000 of IRA income plus half her $38,400 benefit is $67,200, far past the line, so the full 85% of her benefit is taxable: $32,640. Adjusted gross income is $80,640.

Her deductions are the single standard deduction of $16,100, the single over-65 addition of $2,050, and the senior deduction, which is now $6,000 instead of $12,000 and which starts shrinking above $75,000 of income for a single filer. She is $5,640 over, so it is cut to $5,662. Total deductions: $23,812, half of what the couple had.

Taxable income is $56,828. The single 12% bracket ends at $50,400, so about $6,400 of it is taxed at 22%. Federal tax: about $7,200.

Her cash income fell from $109,200 to $86,400. Her federal tax bill went from $3,800 to $7,200. The effective rate on what comes in the door more than doubled, from 3.5% to 8.3%. And it gets worse at 73, when required withdrawals start. On an IRA that has grown to $1.3 million the first required withdrawal is about $49,000, roughly what she is drawing now, but by then the divisor will keep shrinking every year while the single brackets and deductions stay where they are.

What the couple can do while there are two of them

The reason the survivor pays so much is that all the money is still sitting in a traditional IRA, where every dollar that comes out is ordinary income on a single filer’s return. The fix is to move money out of that bucket while the joint brackets and the doubled deductions still apply, by converting to a Roth.

Look at the room they have. Taxable income on the joint return is $35,910, and the 12% bracket runs to $100,800. Every dollar converted is income, and the first $19,500 or so of conversion also drags more Social Security into the taxable column until the 85% cap is reached, so the practical room is about $48,000 a year of conversions before anything is taxed above 12%. That conversion keeps their adjusted gross income near $148,000, just under the $150,000 line where the senior deduction starts to shrink for couples.

At 12% the tax on a $48,000 conversion is about $5,800 a year. Do it for five years, from 68 to 73, and they have moved roughly $240,000 into a Roth for about $29,000 in total tax. That is money that will never be taxed again, never counts toward required withdrawals, and never shows up on the survivor’s single return.

Run the survivor’s return again with $240,000 less in the traditional IRA and the same spending. Her required withdrawals at 73 drop by about $9,000 a year, and if she draws part of her $48,000 from the Roth instead, her taxable income falls out of the 22% bracket entirely. The difference is worth $2,000 to $3,000 a year for the rest of her life, against conversions that cost 12 cents on the dollar.

Two other moves

The first is to take the larger of the two Social Security benefits as late as possible. The survivor keeps the bigger check, so delaying the higher earner’s claim to 70 raises the income she will live on for decades, at no tax cost.

The second is to hold the bond side of the portfolio inside the IRA and the stock fund outside it, in a taxable account, where gains are taxed at the lower capital gains rates and get a stepped-up basis at death. With a 10-year Treasury at 4.95%, the interest is best kept where it is sheltered, and the stock growth is best kept where the survivor can sell it with little or no tax.

The bottom line

For a 68-year-old couple with $1.2 million in traditional IRAs, the survivor’s federal tax bill roughly doubles the year after the first death, from about $3,800 to about $7,200, on less income. Converting about $48,000 a year to a Roth while both are alive and both sets of deductions apply costs 12% now and takes most of that penalty off the table. It is the one piece of retirement planning that has a deadline nobody can see.

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