Does Your Retirement Plan Guard Against the ‘Survivor Trap’?

Most couples spend time talking about retirement and looking forward to the amazing things they’ll do together when they’re no longer working.

Some start those conversations sooner than others, but if they’re smart, by the time they’ve reached their 50s or early 60s, a married couple will have created a solid financial plan that will provide enough income to pay for the retirement lifestyle they have both been dreaming about.

Unfortunately, when they do that planning, many couples avoid or forget to talk about what their finances will look like on a net basis when one spouse passes away and the other is left alone.

A retirement plan that doesn’t include transitioning to widowhood is simply incomplete. And it could easily, and quickly, go off track.

Why? Well, to start with, when a spouse passes, the smaller of the couple’s two Social Security checks automatically goes away. For example, if one spouse was getting $1,700 a month and the other was getting $2,100, the surviving spouse would get only $2,100. That additional $1,700 monthly check would disappear.

If there isn’t another source of income to replace that lost amount, the survivor may have to downsize and/or give up on some of the dreams the couple once had.

And if the replacement income comes from tax-deferred investments, that could lead to another problem — a bigger tax bill.

When a surviving spouse transitions to being a single filer on his or her income tax return, it often results in having to pay more in income taxes — a phenomenon that’s sometimes called the “survivor trap” or “widow’s penalty.” And it works like this:

Single filers get a smaller standard deduction on their income tax return than joint filers do. (For 2020, the standard deduction is $24,800 for joint filers versus $12,400 for single filers. Joint filers who are 65 or older get an additional $2,600 deduction, while single filers who are 65 or older get only $1,650 more.) With that smaller standard deduction and the same or similar amount of taxable income, there’s a good chance the surviving spouse will land in a higher tax bracket and pay a higher tax rate. 

So, for example, a taxpayer who had a 12% tax rate as a married couple filing jointly with a taxable income of $80,000 could see their rate rise to 22% as a single filer with the same taxable income. The difference could cost that person thousands of dollars come April 15.

To add insult to injury, higher-income retirees also could end up paying more taxes on Social Security, a surcharge on Medicare, and, possibly, a surtax on net investment income that they wouldn’t have been subject to prior to their spouse’s death, because the thresholds for these taxes are lower for single filers.

What can a couple do to avoid the “widow’s penalty” and other financial issues surviving spouses often encounter? Here are some steps to consider:

1. 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.
2. 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.
3. 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 required minimum distributions at age 72.
4. 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. 
5. 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.
6. 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.
7. 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. A financial adviser who is knowledgeable about Social Security, taxes in retirement, legacy planning and other retirement-related issues could save you or your spouse from many of the worries that are common in widowhood.     

Kim Franke-Folstad contributed to this article.