What is The Widow’s Tax?
The emotional toll of losing a spouse is profound. Amidst the changes that accompany the grieving process, the surviving spouse must also navigate significant financial changes. One critical aspect to be aware of during this life change is the "widow's tax". The “widow’s tax” is a term that conveys the dual impact of reduced income paired with increased tax burden. In this article, we’ll help provide answers to the question, “What is the Widow’s Tax?”. We discuss how awareness and planning are important keys in helping to mitigate the financial strain that frequently comes with this life-changing loss.
What is the Widow’s Tax?
Under our current laws, when a spouse passes away, the surviving partner faces an immediate change to their financial reality. If both spouses receive Social Security, the most notable change may be the reduction in income due to the loss of one spouse’s Social Security benefit. For a married couple, partners typically receive either their individual social security benefit or receive a spousal benefit based on the higher-earning spouse's record. However, when one spouse dies, the surviving spouse will continue to receive only the larger of the two Social Security, resulting in an immediate reduction in household income.
As a widow or widower, compounding the loss of income is the change in tax filing status and the transition from filing taxes jointly to filing as a single individual. This shift often results in higher tax billfor the surviving spouse. Tax brackets for single filers are less favorable than those for married couples filing jointly, meaning the same level of income may mean a higher tax rate. Additionally, standard deductions and tax credits available to married couples, may not be available for single filers, further increasing the tax burden.
Social Security Changes & Strategies
Given these challenges, strategic planning around Social Security benefits becomes crucial. One effective strategy is for the higher-earning spouse to delay claiming Social Security until the age of 70. By doing so, the monthly benefit amount increases due to delayed retirement credits, providing a larger benefit amount available to support the surviving spouse after one partner passes away. This approach may help maximize the income stream available to the surviving spouse, helping to offer greater financial stability in the long term.
The loss of one Social Security benefit, combined with the increased tax burden, highlights the importance of having additional income sources. Life insurance can play a pivotal role in providing financial security for the surviving spouse. A well-structured life insurance policy may help replace the lost income and help cover expenses, helping to reduce the financial strain during an already difficult time. Periodically evaluating and updating life insurance policies ensures they align with your current financial needs and goals.
For the higher earning spouse, waiting until the age of 70 to claim Social Security helps to enhance the surviving spouse’s income stream. Incorporating life insurance into the financial portfolio provides an additional layer of security, helping to ensure that the surviving spouse has the needed resources to maintain lifestyle level. Regularly reviewing and updating financial plans, including life insurance policies and estate plans, ensures survivors remain aligned with evolving needs and circumstances.
At age 60 or older, a widowed spouse can begin to claim what is termed the Social Security “widow’s benefit”, allowing timely access to the deceased spouse’s benefit. The “widow’s benefit” affords the surviving spouse immediate access to social security income, rather than waiting to receive the normal social security benefit triggered as early as age 62. While taking the spousal benefit, the surviving spouse’s own benefit continues to grow until age 70. At age 70, the surviving spouse chooses one of two Social Security options: opt to receive their individual benefit or elect to continue to collect the “widow’s benefit”, usually selecting the larger of the two benefit amounts.
RMDs, 1035 Exchanges & Life Insurance
It is essential to review your entire financial situation with an advisor to consider the impact on additional income sources. For instance, filing as a single individual and taking Required Minimum Distributions (RMDs) from retirement accounts may push the surviving spouse into a higher tax bracket. The combination of additional income from RMDs and the change in tax status may significantly affect the overall tax burden. Considering the whole financial picture and collaborating with a financial advisor to develop a comprehensive plan, helps manage the tax impact and optimize retirement income.
Life insurance helps function as a financial safety net, offering a lump-sum payment replacing lost income, covering funeral expenses, paying off debts, and helping to meet daily living expenses without additional financial strain. This approach may be a crucial step in offsetting the reduced income related to Social Security benefits and the increased tax burden arising when a spouse passes away.
Additionally, the life insurance policy death benefit is tax-free, providing an immediate, unencumbered source of funds. This supplemental financial support helps provide the surviving spouse time to adjust to new circumstances without the added pressure of financial insecurity, making life insurance an essential consideration as part of a comprehensive financial plan.Whole life insurance policies offer protection to a family should they suffer the death of a key wage earner during middle age years. As a retiree, however, circumstances change, and financial priorities naturally evolve. You may no longer require the coverage provided by the insurance but realize “cashing out” the policy may result in a significant tax liability, thereby diminishing the overall accumulated cash value.
At ClearPlan, we often explore the option of a 1035 exchange with our clients, addressing the dilemma of unneeded life insurance policies while helping to avoid unnecessary, unwanted tax consequences. A 1035 exchange allows investors to transfer the cash value of a life insurance policy directly into a new asset-backed long-term care policy or investment vehicle without triggering an immediate tax liability. Utilizing this tax-deferred exchange alternative, investors might help preserve the value of the accumulated cash value, avoid “cash-out” tax burdens, and explore options more in line with current and projected life stage and financial goals.
Estate Planning & Health Care Considerations
Healthcare costs are an ever-present and significant consideration. A surviving spouse may face higher medical expenses, particularly when previously covered under the deceased spouse's employer-sponsored health plan. Increased medical premiums and unforeseen out-of-pocket health costs may result in additional financial burden, highlighting the importance of including future healthcare expenses as an essential part of an overall financial plan.
Crafting a thorough estate plan is another vital component when preparing for the loss of a spouse. Proper estate planning and routine updates helps ensure accurate distribution of assets according to the deceased spouse's wishes and may help provide tax advantages that preserve the estate's value. Trusts, beneficiary designations, and joint ownership arrangements are several tools that aid in simplifying the transfer of assets while helping minimize tax liabilities for a surviving spouse.
At ClearPlan Wealth Management, we work together closely with our clients, in collaboration with estate planners and tax advisors, helping create thoughtful strategies to address individual circumstances and fulfill final wishes.
Long Term Implications & Estate Taxes
For many surviving spouses, downsizing or relocating can be a practical solution to managing reduced income and increased expenses. Downsizing to a smaller home or relocating to a more affordable area may help lower living costs, freeing up resources to create supplemental income. In addition to the financial implications of relocation, the decision also requires consideration of the emotional and logistical impacts of such a change.
Naturally, many of us want to remain in our homes. Failing to realize a home may have accumulated substantial equity or value, and that value encompasses part of overall net worth. This deliberate oversight may have a dramatic impact on potential estate taxes, family inheritance, as well as otherimportant consequences. At ClearPlan, we collaborate closely with you, reviewing the many possible scenarios, coordinating with your estate attorney, and constructing the best strategies for your individual circumstances and wishes.
The preparation for and awareness of life ahead are vital keys to help mitigate the financial impact of losing a spouse. By taking proactive steps and seeking advice from a trusted professional team, a surviving spouse moves forward informed and better prepared to navigate the challenges of loss. We help guide you through the maze of the widow's tax and other estate tax considerations, potentially helping to you preserve financial stability during a challenging time.
ABOUT THE AUTHOR:
Troy Brewer has a talent for connecting successful people while serving as a respected mentor on the path to prosperity. By facilitating an all-encompassing approach to wealth management, Troy utilizes his extensive network of resources including estate planners, accountants, and business leaders to develop creative financial solutions for his clients. By fostering meaningful relationships, orchestrating financial strategies, and serving as a trusted confidant, Troy helps his clients achieve their desired life and legacy.
Troy has spent more than 25 years in the financial services industry, focusing on maintaining tight multigenerational relationships through a process-driven approach. As a Chartered Retirement Plans Specialist® and member of the Baltimore Estate Planning Council, Troy specializes in low-cost investments, complex / multigenerational wealth planning and tax efficiency. His clients include business owners, corporate executives, and affluent families. Learn more about Troy or schedule a consultation.
RMDs are generally subject to federal income tax and may be subject to state taxes. Consult your tax advisor to assess your situation. Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The forgoing information has been obtained from sources considered to be reliable, but we do not guarantee it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Troy Brewer and not necessarily those of Raymond James.
