It’s called the survivor trap or widow’s penalty. It’s a financial monster that eats away retirement income after one spouse dies, often leaving the surviving spouse with no hope of the retirement they expected. Here are some of the pitfalls of the Survivor Trap.
Loss of Social Security
One of the first things to happen when a spouse dies is a decrease in Social Security income. If both spouses are receiving Social Security benefits, SSA rules allow the surviving spouse to keep the largest of the two payouts but the smaller amount goes away. For example, if the deceased spouse was receiving $3,000 per month and the other receives $1,500 each month, going forward the surviving spouse will receive $3,000. The $1,500 goes away and there is a loss of $18,000 a year of household income. Loss of substantial income can mean selling the house, downsizing, moving in with the kids, or even selling prized possessions to make up for the loss of income.
Taxes on deferred withdrawals
If you have other resources for retirement income, replacing the loss in Social Security may come from tax-deferred accounts such as traditional IRAs or retirement accounts which can create a bigger tax bill. Remember, the government hasn’t taxed that money yet, so when you withdraw money from those types of accounts, you’ll have to pay federal taxes on the withdrawals and state taxes in most states.
Lower standard deduction
Losing a spouse means you now become a single filer, and you will receive a smaller standard deduction than when you were a couple filing jointly. In other words, you don’t get to deduct as much as when your spouse was living.
There is, however, an exception for a Qualifying Widow(er). Taxpayers who do not remarry in the year their spouse dies can file jointly with the deceased spouse. For the two years following the year of death, the surviving spouse may be able to use the Qualifying Widow(er) filing status. To qualify, the taxpayer must:
- Be entitled to file a joint return for the year the spouse died, regardless of whether the taxpayer actually filed a joint return that year.
- Have had a spouse who died in either of the two prior years. The taxpayer must not remarry before the end of the current tax year.
- Have a child, stepchild, or adopted child who qualifies as the taxpayer’s dependent for the year or would qualify as the taxpayer’s dependent except that he or she does not meet the gross income test, or does not meet the joint return test, or except that the taxpayer may be claimed as a dependent of another taxpayer.
- Live with this child in the taxpayer’s home all year, except for temporary absences.
- Have paid more than half the cost of keeping up the home for the year.
Higher tax rate
Another part of the Survivor Trap is the possibility of being pushed into a higher tax bracket resulting in a higher tax bill.
Let’s say your income remains the same after your spouse dies. As a couple filing jointly, receiving the standard deduction for couples, you may have been in the 12% tax bracket. But as a single tax filer receiving the same amount of income and receiving the standard deduction for a single individual, you might be in a 22% tax bracket—same income but a lot more taxes.
But wait, there’s more
If your income remains the same as it was before the death of your spouse, you may now be considered a high-income taxpayer which could mean you’ll pay more taxes on your Social Security, a surcharge on your Medicare, and possibly a surtax on net investment income, all things that didn’t apply when you were in a joint household.
The good news is, with some proactive planning you can avoid the survivor trap. Certified Financial Planner Derek Ghia recommends these planning steps:
- Understand how Social Security benefits work for married couples. Make the most of claiming strategies that can help maximize the benefit the surviving spouse will receive.
- If one or both spouses will receive an employer pension, look at how you can maximize that benefit, as well. Ask your plan administrator about each available payout option, and run through various scenarios to determine how each option would affect a surviving spouse.
- Consider converting money from tax-deferred retirement accounts (401(k)s, traditional IRAs, etc.) to a Roth IRA. A series of partial conversions could be done over a period of a few years to avoid creeping into a higher tax bracket. If the money is in a Roth account, the surviving spouse won’t have to worry about paying taxes on necessary withdrawals or having to take required minimum distributions at age 72.
- Prepare for life alone. Make sure the beneficiary designations are correct on any insurance policies or accounts that could be inherited. Both spouses should know where any important documents are kept and what account numbers and passwords may be needed for access. And both spouses’ names should be on utility bills, leases, titles, etc.
- Don’t let debt become a burden. Try to pay off any debts (credit card accounts, mortgages, and other loans) that could cause a financial strain for the surviving spouse.
- Consider purchasing or upgrading your life insurance policies. Most life insurance payouts are tax-free, so the surviving spouse can use the money for income replacement and avoid the widow’s penalty.
- Have a plan. Make sure both spouses take part in any financial decision-making. Losing a spouse is tough enough without having to worry about your finances. Having a plan for what happens next could make a huge difference in helping the survivor maintain a comfortable lifestyle.
As you can see, there’s a lot to consider when preparing for life after the death of a spouse. Both of you should be actively involved in creating a plan now. Don’t be afraid to ask for advice. Find a reputable professional who specializes in Social Security, retirement taxes, legacy planning, and other issues that will keep you out of the Survivor Trap.
Disclaimer
This information is presented for informational purposes only and does not constitute an offer to sell, or the solicitation of an offer to buy any investment products. None of the information herein constitutes an investment recommendation, investment advice, or an investment outlook. The opinions and conclusions contained in this report are those of the individual expressing those opinions. This information is non-tailored, non-specific information presented without regard for individual investment preferences or risk parameters. Some investments are not suitable for all investors, all investments entail risk and there can be no assurance that any investment strategy will be successful. This information is based on sources believed to be reliable and Alhambra is not responsible for errors, inaccuracies, or omissions of information. For more information contact Alhambra Investment Partners at 1-888-777-0970 or email us at [email protected].
