April 4, 2024

The Marriage Penalty in Widowhood: How Roth Conversions Can Help

5 Key Points

The Marriage Penalty: Surviving spouses face smaller tax brackets, resulting in higher taxes despite reduced income after their spouse passes away.
RMDs Exacerbate the Issue: Required Minimum Distributions from traditional retirement accounts push surviving spouses into even higher tax brackets.
Roth Conversions Can Help: Proactively converting traditional IRA funds to a Roth IRA during your working years lessens RMDs and reduces tax burdens later in life.
Timing is Crucial: Strategically timing Roth conversions while in lower tax brackets (ideally before RMDs kick in) can maximize tax savings.
Legacy Benefits: Roth IRAs offer significant tax advantages for heirs, as withdrawals are tax-free.

Introduction

It seems unfair that one of the most challenging times in a person's life, the loss of a spouse, can also lead to unexpected financial hardship. Yet, many surviving spouses face a frustrating predicament known as the "marriage penalty" in retirement. This tax burden often leaves the bereaved with a smaller income and more money owed to the IRS.

Let's explore what causes this penalty, how Roth conversions can mitigate it, and walk step-by-step through the process of utilizing this strategy.

Understanding the Marriage Penalty

The marriage penalty stems from the disparity in tax brackets between those who file as "married filing jointly" and those who file as "single" following the death of a spouse. Our tax system has progressive income tax brackets, meaning income is taxed at different rates as it moves into higher tiers. Married couples filing jointly enjoy wider tax brackets than individuals filing as single.

Here's how it leads to a penalty for many surviving spouses:

Smaller Tax Brackets: After losing a spouse, a surviving spouse must shift to filing taxes as a single person after two years of the spouse's death (in the two years immediately after, you can file as Qualifying Widow(er)). The single tax brackets are much narrower, meaning income moves into higher tax brackets more quickly.
Required Minimum Distributions (RMDs): If the deceased spouse had traditional retirement accounts like 401(k)s or IRAs, the surviving spouse may inherit those accounts. RMDs (Required Minimum Distributions) become mandatory after age 72, forcing annual withdrawals from traditional pre-tax retirement accounts. These distributions are counted as taxable income.

The loss of the departed spouse's social security could offset some of the tax impact. Still, for families who were strong savers, the loss of social security will be dwarfed by the effect of smaller tax brackets for single filers. This will push the surviving spouse into higher tax brackets, potentially lowering overall income.

To provide a clearer picture of how the marriage penalty affects taxes in widowhood and demonstrate the benefits of Roth conversions, let's work through a numeric example (math alert!). We will calculate the tax liability for both before and after a spouse's death, showing the tax impact with and without Roth conversions.

Example

For simplicity, let's use the following tax rates for single and married filing jointly statuses in 2023:

Married Filing Jointly:some text
- 10% on income up to $22,000
- 12% on income over $22,000 to $89,450
- 22% on income over $89,450 to $190,750
Single:some text
- 10% on income up to $11,000
- 12% on income over $11,000 to $44,725
- 22% on income over $44,725 to $95,375

(Note: These brackets are simplified for the example.)

Before Roth Conversion: Scenario as Married Filing Jointly

Let's assume some base scenario figures for John and Mary, who are now 72 and required to take RMDs:

Total income: $96,500 (Social Security benefits: $40,000 + Other taxable income: $20,000 + Required Minimum Distributions (RMDs) from their traditional IRA: $36,500)

Assuming standard deductions for 2023 for married filing jointly is $27,700, their taxable income is $96,500 - $27,700 = $68,800

Tax liability calculation (simplified):

10% on the first $22,000: $2,200
12% on the next $46,800 ($68,800 - $22,000): $5,616
Total tax liability: $2,200 + $5,616 = $7,816 (8.1% of total income)

Let's look at what happens in our base scenario if one spouse passes away.

After One Spouse Passes Away (Two Years Later): Scenario as Single Filer

In this scenario, we'll consider that John passes away first, leading to an immediate decrease in Mary's collective Social Security income. However, there's a silver lining. For the first two tax years after John's death, Mary can file taxes as a "qualifying widow(er)," providing tax benefits to somewhat ease the financial burden during this challenging period. Nevertheless, our focus will shift to the year after Mary's qualifying widow(er) status's expiration to understand the ongoing financial implications. Here is what Mary's income and tax situation now looks like:

Total income: $80,150 (Social Security benefits: $20,000 + Other taxable income: $20,000 + Required Minimum Distributions (RMDs) from their traditional IRA: $40,150)
Assuming the standard deduction for 2023 for a single filer is $13,850, her taxable income is $80,150 - $13,850 = $66,300

Tax liability calculation (simplified):

10% on the first $11,000: $1,100
12% on the next $33,725 ($44,725 - $11,000): $4,047
22% on the remaining $21,575 ($66,300 - $44,725): $4,747
Total tax liability: $1,100 + $4,047 + $4,747 = $9,894 (12.3% of total income)

So even though Mary's income decreased by $2,500, her taxes increased by $2,078, netting her $4,578 less income to spend.

One solution to this issue is to perform Roth conversions in the years before being required to take RMDs. This solution is very effective but requires multi-year planning.

Solution: Implementing Roth Conversions

A Roth conversion involves moving assets from a pre-tax IRA to an after-tax Roth IRA. While you'll pay taxes on the converted amount in the year of conversion, the benefit is that future qualified withdrawals from the Roth IRA are tax-free. This allows you some control over the timing of the conversion to minimize the tax impact and reduce your overall lifetime tax burden.

Assuming John and Mary begin converting $50,000 annually to a Roth IRA for ten years beginning when they are 62, paying taxes at the 22% rate (for simplicity):

Tax paid on conversions annually: $50,000 * 22% = $11,000
Over ten years, they have paid $110,000 in taxes on conversions but reduced their future RMDs and diversified their tax exposure.

Note: The actual tax rate is lower than 22% in many scenarios. For example, if John and Mary had already retired (reducing their income) and delayed collecting Social Security benefits (recommended), their taxable income would be significantly lower. In this case, Roth conversions could be their primary source of taxable income, resulting in a lower tax burden during the conversion years.

After Roth Conversions: Tax Calculation

Assuming the same income scenario from our previous example for Mary but with the ability to take $20,000 tax-free from the Roth IRA:

Total income (including Roth): $80,150
Total taxable income: $60,150 (This includes Social Security, other income, and RMDs but excludes the Roth IRA withdrawal since it's tax-free.)
Standard Deduction for a Single Filer in 2023: $13,850
Taxable Income after Standard Deduction: $60,150 - $13,850 = $46,300

Tax liability calculation with Roth (simplified):

10% on the first $11,000: $1,100
12% on the next $33,725 ($44,725 - $11,000): $4,047
22% on the remaining $1,575 ($46,300 - $44,725): $346.50
Total tax liability: $1,100 + $4,047 + $346.50 = $5,493.50 (6.9% of total income)

Mary's income has remained unchanged, but taxes have decreased by $4,400.50.

Additional Benefit: Enhanced Inheritance Through Roth Conversions

By converting a portion of their retirement savings from a traditional IRA to a Roth IRA, John and Mary have paid taxes upfront at their current rate, which we've approximated at 22%. This strategy locks in their tax rate on the converted amounts, circumventing the uncertainty of future tax rates and the potential for higher rates as their heirs inherit the funds.

Impact on Heirs

Tax-Free Inheritance: The Roth IRA balance grows tax-free after the conversions, and the heirs will not be taxed upon its withdrawal. This is in contrast to the traditional IRA, where the heirs' withdrawals are taxed based on their income tax rates.
Avoiding Higher Tax Rates for Heirs: Given that the heirs might be in their prime working years when they inherit the Roth IRA, their marginal tax rates could significantly exceed the 22% rate at which John and Mary locked in by performing the conversions. For heirs potentially in the 24%, 32%, or even higher tax brackets, the savings can be substantial.
Benefit Illustration: If Mary's heirs are in the 32% tax bracket and inherit a traditional IRA, every $100,000 withdrawn would incur $32,000 in taxes. In contrast, the same amount from a Roth IRA would be entirely tax-free, preserving the full value of the inheritance.

Conclusion

The marriage penalty in retirement shouldn't add to the burden of losing a loved one. While the pain of loss is unavoidable, proactive Roth conversions are a powerful way to ease the financial strain that often follows. By strategically shifting some of your retirement funds to a Roth IRA during your working years, you can reduce potential future tax burdens, ensure a smoother transition during a difficult time, and leave a greater, more tax-efficient legacy for your heirs. Consulting a financial advisor can help develop a Roth conversion plan tailored to protect your financial security – both in the present and in the years to come.

If you have questions about planning for your retirement, legacy, or want to explore how a Flat-Rate Fee-Only structure can help you achieve your goals, schedule a time to talk.

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Your financial well-being is too important to leave to chance. Choose wisely.

FAQs

Q: Am I eligible for Roth conversions?

A: While there are no income limits for Roth conversions, "backdoor" strategies may be necessary for high earners. A financial advisor can help.

Q: How much should I convert to a Roth IRA each year?

A: The ideal conversion amount depends on your income, tax bracket, and overall financial plan. Consulting a financial advisor is crucial for personalized guidance.

Q: Are there any downsides to Roth conversions?

A: The primary consideration is paying taxes on the converted amount in the year of conversion. Careful planning can minimize the tax impact.

Q: What is the five-year rule for Roth IRA conversions?

A: Withdrawals of earnings on converted funds within five years of conversion may incur taxes and penalties. There are important exceptions, and consulting an advisor is important.

Q: Can Roth conversions help if my spouse has already passed away?

A: While the benefits are greatest when conversions are done proactively, careful analysis can still determine if conversions are advantageous for the surviving spouse as part of an overall financial strategy.