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Death and Taxes

John Yeigh

TAX-DEFERRED accounts are great, until they aren’t—when we have to pay taxes on our withdrawals. Millions of Americans have tax-deferred accounts, pundits laud them, companies help fund them, institutions service them and markets help them grow. But when it comes time to empty them, often the only person to guide us is Uncle Sam, who’s patiently awaiting his cut.

Efficiently managing 30 years of retirement withdrawals from a 401(k), 403(b), IRA or other tax-deferred account is just as important as the 40 years of accumulation. While we could just follow the government’s required minimum distribution (RMD) rules beginning at age 70½, who says these rules are optimal? Granted, the normal playbook is to postpone paying taxes for as long as possible. Heck, “deferred” is the way these accounts are described.

Yet deferring may not be right for everyone. There are some widely discussed reasons to make earlier and larger withdrawals from tax-deferred accounts—to convert this money to a Roth IRA, to avoid future tax rate increases, to use the money while still young and healthy, and to reduce future RMDs by making withdrawals earlier in our 60s, when we might be in a lower tax bracket.

Married couples have an often-overlooked additional reason to consider extra early withdrawals: Their taxes will almost certainly increase after the first spouse dies. Think of this as the widow or widower’s tax. It’s is an issue I recently discovered when I was weighing how much to withdraw from the retirement accounts owned by my wife and me.

What’s the problem? First, the standard deduction for the surviving spouse will typically decline from $24,400, the 2019 level for those married filing jointly, to $12,200 for a single individual. In addition, the surviving spouse will lose the additional “over age 65” deduction of $1,300 for the deceased spouse.

Assuming the same income and a 22% marginal tax rate, the surviving spouse’s tax bill will increase $2,970 from lost deductions alone. On top of this, tax rates also increase. While the change to filing as a single individual increases tax rates by only two percentage points for a large portion of middle-income surviving spouses, tax rates can jump as much as eight to 11 percentage points at certain income levels, as shown in the table below for 2019. In particular, check out the tax-rate increases for the taxable-income ranges highlighted in bold:

Married couples with annual incomes around $40,000 to $80,000, or above $160,000, are likely to get hit with significantly higher tax rates upon the first spouse’s death. Today’s tax rates are unusually low. That means the tax penalty could be even higher, depending on the results of 2020’s election. It could also be higher after 2025, when today’s low tax rates are slated to return to pre-2018’s higher levels.

How can married couples take advantage of today’s low tax rates? If their taxable income is around or only moderately above $39,500 in 2019, couples might consider additional withdrawals from tax-deferred accounts, perhaps up to a taxable income of $78,950. That’s the equivalent of $103,350 in total income, once you figure in the standard deduction. The married marginal tax rate remains a miserly 12% at these income levels. Paying taxes at this rate may allow the surviving spouse to avoid paying taxes at a much higher rate later on.

Likewise, if income is already above $160,000, couples might consider tax-deferred account withdrawals to achieve a taxable income of as much as $321,450, equal to $345,850 in total income, after factoring in the standard deduction. Even at this very high income, the marginal tax rate remains a relatively modest 24%.

Keep in mind that this additional taxable income may trigger higher taxes on your Social Security benefit or higher Medicare premiums, and perhaps both. Don’t plan to spend these extra withdrawals in the near future? The best strategy is probably to convert this money to a Roth IRA.

John Yeigh is an engineer with an MBA in finance. He retired in 2017 after 40 years in the oil industry, where he helped negotiate financial details for multi-billion-dollar international projects.  His previous articles include Take a Break7,000 Days and Window Dressing.

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james mcglynn
james mcglynn
1 year ago

Excellent analysis of the “widow’s tax”. Even though the “difference” column shows tax rates increasing up to 11% “points” more (if the tax rate increases from 24% to 35%) that would be an increase of marginal taxes paid of 46%! (35/24=45.8%). Harsh!

Rick Connor
Rick Connor
1 year ago

Great analysis John. My wife and I have about 8 years until RMDs kick in. I’m thinking about building a projection of the next 10 years to guide withdrawals and or Roth conversions. This provided more motivation to create a framework to help guide future decisions.

Peter Blanchette
Peter Blanchette
1 year ago

The decision whether or not to convert to a Roth IRA is NOT simply a matter of marginal tax rates. It is marginal AND effective tax rates. The author should read the following to educate himself. It is not clear what is being explained except that tax deferred savings could be bad but without any real analysis of the issue.

https://www.kitces.com/blog/why-a-roth-conversion-may-be-a-bad-idea-even-if-taxes-are-higher-in-the-future/

John Yeigh
John Yeigh
1 year ago

The widowwidower tax impact for the surviving spouse is an often overlooked fact and independent of whether deferred-tax account withdrawals are increased or converted to Roth or not. Both increased withdrawals and Roth conversions do provide couples with discretionary alternatives to potentially help manage and tax-optimize this issue. Other alternatives such as adjusting the timing of other income, deductions or donations could similarly help couples manage taxes particularly if one spouse had longevity risk or a life-threatening illness.

energyNOW_Fan
energyNOW_Fan
1 year ago

Hey John very nice article. Doing some year end planning right now trying to decide how Roth IRA conversion is best this year. This helps me convince my spouse on it. Nice that the new SECURE act seems to give us a few more years for Roth conversion.

brian_in_arizona
brian_in_arizona
1 year ago

A different angle: IRAs and 401Ks both tax all distributions as ordinary income. The lower tax rates that apply to dividend and capital gains income do not apply. Moreover, any assets remaining in these plans upon the death of the surviving spouse are fully taxable as ordinary income to heirs.

This is totally different from non tax-preferenced assets, which now enjoy the “step up” basis used to calculate the cost basis for later sales. $100,000 held in an IRA that is inherited by a child becomes $100,000 of ordinary income, while the same assets held outside the IRA (unless in an annuity) enjoy a step-up cost basis to $100,000 and can be sold immediately by the heirs with no tax impact.

Bottom line, these tax-deferred instruments are not as great a vehicle as they appear to be for higher-wealth households.

Ian
Ian
1 year ago

Another angle to keep in mind, is that if a married couple is on Obamacare as we are, then it is critical to keep income under 60-64K. Go one dollar over the cut-off and (my) premiums go from negligible to almost $20K. I don’t dare work part-time until I qualify for Medicare in three years.

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