It’s called the survivor trap or widow’s penalty. It’s a financial monster that eats away retirement income after one spouse dies, often leaving the surviving spouse with no hope of the retirement they expected. Here are some of the pitfalls of the Survivor Trap.
Loss of Social Security
One of the first things to happen when a spouse dies is a decrease in Social Security income. If both spouses are receiving Social Security benefits, SSA rules allow the surviving spouse to keep the largest of the two payouts but the smaller amount goes away. For example, if one spouse receives $3,000 per month and the other receives $1,500 each month, the surviving spouse will receive $3,000. The $1,500 goes away and there is a loss of $18,000 a year of household income. Loss of substantial income can mean selling the house, downsizing, moving in with the kids, or even selling prized possessions to make up for the loss of income.
Taxes on deferred withdrawals
If you have other resources for retirement income, replacing the loss in Social Security may come from tax-deferred accounts such as traditional IRAs or retirement accounts and that can lead to a bigger tax bill. Remember, the government hasn’t taxed that money yet, so when you withdraw money from those types of accounts, you’ll have to pay federal taxes on the withdrawals and state taxes in most states.
Lower standard deduction
Losing a spouse means you now become a single filer on your income tax return which often means you have to pay more income taxes. Single filers get a smaller standard deduction than joint filers. In 2021, the standard deduction for joint filers is $25,100 versus $12,550 for single filers.
Lower senior citizen deduction
In addition, taxpayers 65 or older get an additional deduction. In 2021, joint filers receive an extra $2,700 deduction. Single filers get $1,700.
Higher tax rate
Even if your income stays the same as before your spouse passed away, the lower standard deduction and lower senior citizen deduction may push you into a higher marginal tax bracket.
Let’s assume a taxable income of $80,000. In 2021, joint filers would be in the 12% tax bracket while single filers would be in the 22% bracket. As a single filer, that’s a lot of additional money you’ll have to pay in taxes.
But wait, there’s more
If your income remains the same as it was before the death of your spouse, you may now be considered a high-income taxpayer which could mean you’ll pay more taxes on your Social Security, a surcharge on your Medicare, and possibly a surtax on net investment income, all things that didn’t apply when you were in a joint household.
The good news is, with some proactive planning you can avoid the survivor trap. Certified Financial Planner Derek Ghia recommends these planning steps:
- Understand how Social Security benefits work for married couples. Make the most of claiming strategies that can help maximize the benefit the surviving spouse will receive.
- If one or both spouses will receive an employer pension, look at how you can maximize that benefit, as well. Ask your plan administrator about each available payout option, and run through various scenarios to determine how each option would affect a surviving spouse.
- Consider converting money from tax-deferred retirement accounts (401(k)s, traditional IRAs, etc.) to a Roth IRA. A series of partial conversions could be done over a period of a few years to avoid creeping into a higher tax bracket. If the money is in a Roth account, the surviving spouse won’t have to worry about paying taxes on necessary withdrawals or having to take the required minimum distributions at age 72.
- Prepare for life alone. Make sure the beneficiary designations are correct on any insurance policy or account that could be inherited. Both spouses should know where any important documents are kept and what account numbers and passwords may be needed for access. And both spouses’ names should be on utility bills, leases, titles, etc.
- Don’t let debt become a burden. Try to pay off any debts (credit card accounts, mortgages, and other loans) that could cause a financial strain for the surviving spouse.
- Consider purchasing or upgrading your life insurance policies. Most life insurance payouts are tax-free, so the surviving spouse can use the money for income replacement and avoid the widow’s penalty.
- Have a plan. And make sure both spouses take part in any financial decision-making. Losing a spouse is tough enough without having to worry about your finances. Having a plan for what happens next could make a huge difference in helping the survivor maintain a comfortable lifestyle.
As you can see, there’s a lot to consider when preparing for life after the death of a spouse. Both of you should be actively involved in creating a plan now. Don’t be afraid to ask for advice. Find a reputable professional who specializes in Social Security, retirement taxes, legacy planning, and other issues that will keep you out of the Survivor Trap.