Minimize the "Widow's Penalty" Tax with a Roth Conversion

If you haven’t heard of the so-called “Widow’s Penalty,” it might be because you’re not approaching retirement age yet. If you are getting close to retirement, though, you should pay attention. That’s because a situation inherent in the tax code, commonly known as the “Widow’s Penalty, could require you to pay higher taxes if your spouse dies, and the best time to safeguard against the penalty is before you actually retire.

What is the Widow’s Penalty, exactly? Let’s take the example of Wendy and Jerry, two retirees in their late 60s. Both receive Social Security, pension income, and distributions from their 401(k)s or IRAs. With taxable income of $100,000 for 2019, the couple is in the 22-percent tax bracket, and would pay $9,086 plus 22 percent of the amount over $78,950.

Unfortunately for Wendy, Jerry suffers a heart attack and dies in 2019. For this tax year, Wendy will still be eligible to file as “married filing jointly” and will be in the 22-percent bracket. However, in future years, unless she remarries, Wendy will become a single filer.

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Let’s say that in 2020, Wendy’s income will drop, but not by much, because she is Jerry’s beneficiary. Wendy inherits Jerry’s IRA, which increases her required minimum distribution, or RMD, based on her remaining life projection.  With 2020 taxable income of $90,000, Wendy is surprised to discover that her tax bracket is now 24 percent, and that she will owe $14,382.50, plus 24% of the amount over $84,200. What could Jerry and Wendy have done to mitigate or prevent a situation like this?

Roth Conversion to the Rescue

More and more, couples preparing for retirement are looking into converting part of their traditional IRAs, which are tax-deferred, into a Roth IRA, which uses after-tax income. If Wendy and Jerry had started converting a portion of their traditional IRAs after age 59 ½ (but before they claimed Social Security), they may have been able to do so at a lower tax rate. (Of course, it’s never too early to start the planning process, but this is one possible scenario.) They could continue to make conversions over several years, keeping the amount within a lower tax bracket. By doing this, they would not be subject to the 10-percent early distribution penalty (assessed to those who withdraw before age 59 ½), and their tax rate on the conversion would be a the lower, joint-filing rate. Then, because Roth IRAs do not have RMDs, Wendy and Jerry would not have to start taking distributions at 70 ½ unless they wanted to, without any additional taxes due.     

Consult an Adviser as You Prepare for Retirement

At AMDG Financial, we integrate tax, financial and investment strategies for our clients, because we realize each strategy depends on the others for success. In my practice over the years, I’ve found that clients who choose to ignore the tax implications of their investments and financial decisions may do so at their peril. Nothing’s worse than seeing someone face a huge tax bill that they could have avoided with proper planning!

If you are approaching retirement age and don’t yet work with an adviser, the time may be right for you to get a second opinion on your plans. Through AMDG Financial’s Fiduciary GPSSM process, you get an opportunity to see how we work and what we’ll recommend before you commit to an advisory relationship. It’s a great way to learn and experience the value of professional financial advice.

The first step is to schedule an appointment and tell us more about your situation. We’d be glad to help you explore your options, including a Roth conversion, if that’s appropriate for you. You can also call us, at 734-737-0866 if you have questions. We’d be glad to help.

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