I recently attended a celebration of life for a good friend who passed. It got me thinking about the widow’s penalty and what it means for the surviving spouse, beyond the nightmare of losing a spouse and companion, of course.
It is common for spouses to leave their life savings to each other. Yes, there are more advanced estate planning techniques that can spread the money between the widow/widower, children, foundations, charities, etc. Still, these strategies are utilized mainly by the uber-wealthy trying to avoid getting hit with the estate tax. Even in these cases, the surviving spouse is usually left with more than enough money/income to live a comfortable retirement.
Beyond the loss of companionship when a spouse passes, there can also be financial and tax consequences. This is often described as the widow’s penalty. Sorry guys, at least stereotypically, the guys die first. As a fan of The Golden Girls, this was a show about three widows and a divorcee who often wished her ex-husband was dead.
For clarity, I will use the term widow for the surviving spouse. But the situation here is the same if we are talking about a widower. Similarly, nothing changes if we talk about gay married couples or lesbian married couples in which one spouse has passed.
You are probably wondering, what the heck is the widow’s penalty? If she inherits all the household assets, she should be fine, right? In some cases, surviving spouses may end up with more assets or even a higher cost basis in the assets they already owned (i.e., receiving life insurance proceeds). Also, if they own the family home, they will receive a step-up in cost basis on the decedent’s half of the house. Similarly, the widow may benefit from a step-up in basis on highly appreciated stocks and bonds. These things could make the home and investments more valuable if they need to be sold.
Other income streams may disappear, for example, Social Security. The household would go from two checks to one. Luckily, the surviving spouse can continue to receive the larger of the two Social Security benefits. Additionally, if there is a pension or annuity income based on a single life, this income will likely disappear.
Example of the Widow’s Penalty in Action
Consider my clients Jim and George. They lived a dream retirement with a combined income above $350,000 per year and multiple homes. Life was good. Then George became ill and passed. Jim inherited all of George’s assets. They both had substantial earnings throughout their careers, but George’s passing meant Jim would be losing more than $42,000 per year in Social Security benefits. Adjustments could and would need to be made to offset this loss of Social Security benefits.
The widow’s penalty kick in the nuts came later when Jim filed his taxes for the first time as a single filer. Suddenly, he was going to have to pay more taxes on a smaller income. The problem was magnified as Jim is a resident of a high-tax state, California. His federal income tax rate went up, as did his state income tax bracket.
Jim and George funded their retirement income with a combination of taxable withdrawals from a traditional IRA, tax-free Roth IRA distributions, two Social Security benefits and income from investment accounts taxed as capital gains. Some of their taxable income was pushed into higher tax brackets, and more of their income fell into their current top tax bracket at both the state and federal levels. They also saw a large Obamacare 3.8% surtax on investment income when filing as single. Now, Jim will have a smaller standard deduction as a widower than when George was alive.
The good news here is that they planned well for a financially secure retirement. Jim will get by and adjust his spending to accommodate his new high bills and reduced income. Many retirees will not have this luxury. Some expenses will go away or become cheaper with the passing of a spouse, things like cell phone plans, medical insurance, and care, and even car payments. Other expenses are the same regardless of how many people are in your household, like cable, mortgage, property taxes and, for the most part, utilities.
While Jim and George spent decades investing to fund a retirement income stream they wouldn’t outlive, they never thought about the widow’s penalty until they began working with me as their financial planner. The widow’s penalty is problematic now but could grow if tax rates increase in the future. While I don’t pretend to know exactly what tax brackets will look like in 20 years, I would be surprised if they weren’t substantially higher than they are today. Luckily for Jim (and George), they had an income with diversified taxation (taxable, pre-tax, Social Security (which has favorable tax) and capital gains), which has partially muted the widow’s penalty for Jim. If their income stream were 100% from taxable accounts, the widow’s penalty would have been much more painful.
The Widows Penalty: Beyond Taxes
There is another way widows are often penalized when their spouse passes- MEDICAL BILLS. When your spouse is sick or in need of Long Term Care, you are most likely not thinking about your monthly budget. End-of-life care can sap retirement savings and may even leave the surviving spouse with a pile of medical debt or depleted savings due to Long Term Care costs. Few households have enough money to pay for long-term care for one spouse, let alone two. In scenarios like this, the widow’s penalty can be harsh, loss of income sources, a smaller nest egg to generate retirement income, and higher taxes on the income that is left.
The Qualified Widow Exemption
There is a small exemption to help avoid the widow’s penalty for two to three years. This exemption only applies if you have a dependent child living with you. So, I’m going to say this won’t apply to most retirees, although there is an exception. As a gay financial planner, I work with many gay couples who have children later in life. In some cases, they retire, but their kids are not yet out of the house.
A qualified widow or widower is a specific tax-filing status that allows the surviving spouse to use the married filing jointly tax status for up to two years following the death of the spouse. This is in addition to the year of death, in which the surviving spouse can potentially still use the married filing jointly status.
If you find yourself a widow or widower, do yourself a favor and be proactive about financial changes that may be needed, such as adjustments to your taxation and changes to your retirement income withdrawal strategies. Similarly, don’t forget to update your beneficiaries and update your life insurance and long-term care coverage.
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