The “survivor trap” can catch spouses off guard, leading to higher taxes after the loss of a loved one. However, with careful planning, there are strategies to mitigate its impact.
This trap typically emerges in the years following a spouse’s death when the surviving spouse transitions to filing as a single taxpayer, often resulting in a higher tax bill. Factors contributing to this include the change in filing status potentially pushing the surviving spouse into a higher tax bracket, and the loss of certain tax breaks available to married couples.
These challenges are particularly pronounced during retirement, especially when required minimum distributions (RMDs) come into play.
To navigate the survivor trap, financial advisers recommend proactive planning and strategic moves. While the goal isn’t to entirely eliminate taxes, it’s to manage the situation so that the surviving spouse isn’t overwhelmed by both a drop in income and an increase in taxes.
Here are six strategies to help mitigate the survivor trap:
- Taxable accounts and Roth conversions: Couples are advised to position certain investments before retirement to increase flexibility in mitigating tax implications after one spouse passes away. This may involve ensuring there are investments within taxable accounts not subject to RMDs, providing income without mandatory withdrawals and allowing for other strategies to minimize tax consequences.
Owning stocks can offer tax advantages, especially if you refrain from selling them. In the event of a sale, a surviving spouse can benefit from a “step-up in basis,” eliminating the capital gain that accrued between the original purchase and the spouse’s death. Additionally, any capital gains realized would be taxed at long-term capital gains rates, which are typically lower than the ordinary rates applied to RMDs.
Another strategy involves converting traditional individual retirement accounts (IRAs) to Roth IRAs. While you’ll incur taxes on the conversion, Roth IRAs do not mandate RMDs, except when inherited from a non-spouse. RMDs typically commence at age 72 and will rise to age 75 in 2033.
However, there are various factors to consider with a Roth conversion strategy. These include the immediate tax implications of the conversion and when the funds may be required, as noted by Duncan Campbell, private-wealth practice leader at Chicago-based Baker Tilly.
- Charitable Contributions: Consider increasing charitable contributions to itemize expenses and boost deductions. Lisa M. Mela, a certified public accountant, suggests employing a qualified charitable distribution (QCD) directly from a traditional IRA, where up to $100,000 of an RMD can be donated to charity tax-free. Alternatively, compressing charitable contributions into one year to itemize, followed by taking the standard deduction in the subsequent year, can also be beneficial.
- Gifting: Mitigate the survivor trap by gifting income-producing assets, like stocks or bonds, to children or grandchildren in lower tax brackets. Gifting reduces the giver’s gross estate and lowers the surviving spouse’s tax burden. Individuals can gift up to $18,000 in 2024 without triggering the gift-tax filing requirement.
- Harvest Capital Losses: Use a capital-loss-harvesting strategy to offset capital gains. Sell securities with losses to offset gains and potentially other income. Excess losses can be used to offset ordinary income up to $3,000, with any unused losses carried forward indefinitely.
- Take Advantage of Age Disparity: For couples with an age disparity, consider a spousal rollover IRA for the surviving spouse to eliminate or reduce RMDs based on the younger spouse’s age. This strategy can also allow for annual contributions to the IRA based on earned income, potentially reducing future tax burdens.
- Relocate: Selling the family home and moving to a state with lower income taxes, such as Florida, can reduce tax burdens for a single spouse. However, ensure proper documentation to demonstrate a legitimate move and avoid potential audit issues.
These strategies can help mitigate the tax impact on surviving spouses and provide financial stability during challenging times.