Switching your tax status at the death of your spouse from filing jointly to filing as a single person as well as a few other changes that occur after losing a spouse, could mean a dramatically higher tax bite. However, there are ways to ease that burden.
The death of a spouse can be especially devastating when the loss also leads to financial insecurity. An income plan could change markedly, based on whether both spouses were included in any pension-plan benefits. The surviving spouse will also receive only one payment from Social Security—whichever was the larger of the two.
It’s the income tax that really makes a big change for the surviving spouse. He or she will move from married filing jointly to single status. The standard deduction and exemptions will be reduced by half, resulting in more tax on the income at higher rates. In addition, the money that's in a couple's tax-deferred saving accounts (401(k), 403(b), traditional IRA, etc.) will be 100% taxable when it's withdrawn. Therefore, the surviving spouse likely will be adding even more to his or her tax burden.
Here’s an example of a hypothetical couple: Geoff and Cindy. The couple has a combined $30,000 from Social Security and another $30,000 from an IRA. Because they're married filing jointly, only 23% of their Social Security is subject to income tax. As a result, they have $60,000 in income, but only $36,850 is subject to federal taxes. Their standard deduction and personal exemptions take care of about $23,200, which means they have a taxable income of $13,650. That puts them in the 10% tax bracket, and they pay $1,365 in federal taxes.
Geoff passes away unexpectedly, and Cindy is left on her own. While some expenses may change, property taxes, home and auto insurance and utilities will be about the same. Cindy will get the higher of the couple's two Social Security payments, but it's only $20,000 per year. Thus, to keep the same lifestyle she had when her husband was alive, she'll take more out of her IRA—$40,000. But now 85% of her Social Security will be subject to income tax. That’s because the amount she'll pay is based on a single filer. Cindy will have $57,000 of taxable income but just one exemption and half the standard deduction. Her taxable income will be $45,100. That puts her in a 25% tax bracket. She'll pay $7,046 in federal taxes. That’s quite a difference. In fact, it’s a 416% increase!
Cindy can still file as married filing jointly in the year of Geoff's death. That allows her to make a lot of changes. She can use Geoff's life insurance to pay the taxes when she converts the old traditional IRA to a new Roth IRA. In the future, there’d be no taxes on the distributions she takes (after holding the account for five years, within the first five years of conversion, she may be taxed on the gains)—and no required distributions when she turns 70½. This gives her much more control over her tax rates.
Here, its Geoff's tax-free death benefit that makes it possible for Cindy to convert to a Roth IRA. She would save $7,046 in federal taxes during a stressful time, and she'll continue to save on her taxes every year.
Reference: Kiplinger (October 13, 2017) “How Losing a Spouse Could Boost a Survivor's Taxes”