Beware the 'widow's penalty' tax trap

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When it comes to finding the ideal client, advisors might want to look for seniors on a date night.

Based on Fed data, the website Don’t Quit Your Day Job estimates that the median non-residential net worth for those age 60 to 64 is more than $105,000. For those 80 and older, it is more than $120,000. No age bracket under 55 comes close.

Indeed, people who have built wealth over six or more decades can be prime clients. That is particularly true for senior married couples. These families often want an ongoing relationship with an advisor: They’ll need help planning their saving and spending in retirement and navigating the financial fallout after the first spouse dies. Advisors can then demonstrate their value by helping trim what’s known as the widow’s penalty tax on the surviving spouse. There’s also the potential for long-term engagements with the couple’s children.

Detailed planning should begin as early as possible. Laird Green, a financial advisor with Abacus Planning Group in Columbia, South Carolina, recently worked with a couple who wanted the working spouse to retire within three to five years. “We reviewed their cash flow plan, including a savings plan until retirement,” Green says.

Green says that clients “find urgency” around their future cash flow as they near and enter retirement. In this couple’s case, following a savings plan for the next few years is essential for them to achieve their desired retirement lifestyle.

Is the goal to reach a suitable investment amount for implementation of the 4% rule for portfolio drawdown? “The 4% rule provides a good back-of-the-envelope number,” says Green, but her firm goes further. She enters an array of data — such as estimated portfolio values and potential inheritances — into Money Tree’s Total Planning program to see if positive outcomes result.

Green also runs 10,000 Monte Carlo simulations. She feels comfortable if the successful results for a client are around 75% or higher. If they aren’t, she might recommend moves to raise cash, such as selling a second home.

Clients — especially those with a lot of equity in their primary home — should consider opening a reverse mortgage line of credit early in retirement, suggests Bob Lepson, vice president of wealth management at Adviser Investments in Newton, Massachusetts. Due to reverse mortgage technicalities, the credit line increases over time and doesn’t need to be tapped unless needed.

“Startup costs must be considered,” says Lepson, “but this vehicle is worth exploring for folks who are concerned about their liquidity in retirement.” Having this line of credit can help “sidestep” the sequence of returns risk, Lepson adds, referring to the danger of a steep market drop near the onset of retirement. Borrowing could provide an alternative source of retirement spending money after market declines and create more opportunity for the portfolio to recover.

If both members of the couple are listed as borrowers on a reverse mortgage, after the death of one spouse the survivor can remain in the house with the same loan terms. Withdrawals are not taxed.

The 'widow's penalty' tax trap

After a spouse’s death, the survivor will eventually go from a joint return to being a single filer. The widow or widower’s tax bracket likely will rise, resulting in a plumper tax bill.

This bracket creep occurs because the survivor’s taxable income may be about the same as it was on a joint return. (The reduction in taxable income from the loss of one Social Security check may will be partially or fully offset by a smaller standard deduction.)

“I have clients who would go from a 24% tax bracket, filing jointly, to a 32% bracket for the survivor,” says Bob Morrison, founder of Downing Street Wealth Management in Greenwood Village, Colorado. The result will be thousands of dollars a year in extra tax payments. As a single filer, the surviving spouse also could owe more tax on Social Security benefits or face more exposure to the 3.8% surtax on net investment income.

So what actions can couples take? For one, it is important to address the widow’s penalty while both members of the couple are alive.

“After age 59-1/2, but before they begin taking Social Security benefits, they probably can convert part of their traditional IRAs to Roth IRAs at a lower tax rate,” says Judy Ludwig, vice president of planning and taxation at Adviser Investments. The 10% early distribution penalty won’t apply then and the conversion would be taxed at the lower joint filing rate. Moreover, Roth IRA conversions reduce taxable RMDs from traditional IRAs after age 70-1/2.

Today’s tax rates for married couples filing jointly are relatively low, no higher than 24% on taxable income (after deductions) up to $321,450. That same income would put a single filer in the 35% bracket.

A series of partial conversions should be done over a period of years, taking care to keep the amounts within low tax brackets. “For the money moved to the Roth IRA, there are no RMDs for the owner or the surviving spouse," Ludwig says. "Therefore, the account can continue to grow or be used with no tax consequences.” Drawing down a reverse mortgage line of credit or taking life insurance policy loans could be other sources of cash flow that won’t trigger highly taxed income.

Many clients in or near retirement want to ensure their financial legacy, says Green. Careful and sophisticated planning can provide more income for the surviving spouse, a larger inheritance for the next generation and more opportunities for financial planners.

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Retirement income Estate planning Roth IRAs Reverse mortgages Tax planning Retirement withdrawals Social Security benefits