How To Beat The 'Widow's Penalty' Tax


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The so-called marriage penalty is well known, but the more obscure widow's penalty is just as bad if steps aren't taken to mitigate it.

How does it work? Just like a married couple may owe more income tax than two singles, especially if their earnings are equivalent, a widow (or widower) can end up paying more tax after a spouse dies.

You can take steps to guard against these extra taxes that a surviving spouse can end up owing. The penalty can be an added burden for couples whether they are young, middle aged or retired.

When one spouse dies, the survivor typically has similar or only slightly less taxable income than the married couple had reported. Yet the widow or widower generally files singly, rather than on a joint return.

The result is a much higher tax rate. This year's increase in tax rates, new surtaxes and new stealth taxes have made this problem more pressing for high-income retirees.

For example, the 3.8% Medicare surtax on net investment income kicks in at $250,000 of modified adjusted gross income for couples filing jointly. The threshold for singles is $200,000.

Say a married couple has reported $240,000 of MAGI, avoiding the surtax. If the surviving spouse has $220,000 of MAGI, as a single filer, she would likely owe the extra 3.8% on investment income.

You don't have to be at that income level to feel the added tax bite. Suppose hypothetical Al and Ann Ball are retired, with $70,000 in taxable income, after deductions. They're in the 15% tax bracket.

Then Al dies. Ann files singly, with $60,000 of taxable income. Now she's in the 25% bracket. Taxes will take more of her income.

Fighting Back

Advance planning can help. "One tactic is to convert traditional IRAs to Roth IRAs," said Ed Slott, an IRA expert in Rockville Centre, N.Y. After five years, Roth IRA withdrawals are untaxed. You must be at least age 59-1/2.

If the Balls had converted their IRAs, Ann could tap her Roth account tax-free after Al's death. So her higher tax bracket wouldn't impact that source of cash flow. And her reduced taxable income could hold down her tax rate.

But Roth IRA conversions trigger tax bills in the year they're done. That can push you into a higher tax bracket. You might avoid that by doing a series of yearly conversions instead of converting an account all at once.

Say that a working couple have $200,000 of taxable income this year. Their traditional IRA balances total $100,000. They're in the 28% tax bracket, which goes up to $223,050. They could convert $23,000 of their IRAs to Roths and stay in the 28% tax bracket. They'd pay as much as $6,440 on that.

By doing similar conversions over a few years, such a couple could convert most or all of their IRAs to tax-free Roths by the time they retire. That would take the sting out of the future widow's penalty.

Worried that unexpected income might lead to converting too much? One solution is to convert most or all of your IRA to a Roth this year. Once you prepare your 2013 tax return and know your taxable income for the year, you can recharacterize (undo) just enough of the conversion to leave you with an amount that fills up your tax bracket.

Say you convert $100,000 of your IRA by year-end. You discover your taxable income for 2013 is $200,050, without the Roth conversion. Then you could recharacterize 80% of the conversion, leaving you with $20,000 in taxable income to fill out your tax bracket.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Mutual Funds

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