Surviving Spouse's Finances

The economic impact that a spouse’s death can incur. Ed fills you in on what to watch out for.

A married federal employee or retiree has done everything to prepare for a financially secure retirement for himself or herself and his or her spouse. Suddenly the federal employee or retiree dies. What will be the economic impact on the surviving spouse?

About 1.5 million Americans become widows and widowers in a normal year, but the Covid pandemic has increased that number significantly. The National Center for Family and Marriage Research at Bowling Green University estimated that as of November 1, 2021, 380,000 of the 700,000 people in the US who died from Covid were married.

 Over the past two years during the Covid pandemic, there have been numerous cases of federal employees and retirees suddenly passing away as a result of Covid. The economic impact on the surviving spouse can be severe. In the case of a deceased federal employee, there is the end of the employee’s paycheck. In the case of a deceased federal annuitant, the full annuity check (CSRS or FERS) will cease. Assuming the deceased annuitant elected to give the maximum survivor annuity (50 percent) to the surviving spouse, the surviving will receive only half of the FERS annuity income. If both spouses are eligible for and collected their own Social Security retirement benefits, then only one Social Security monthly benefit (the higher of the two Social Security monthly checks) will continue.

This column discusses how a lack of preparation for a spouse’s death can severely imperil the finances of the surviving spouse. Also discussed are some planning steps that couples can perform to protect the finances of the surviving spouse.

Tax-Bracket Shifts and Reduced Taxable Income

The year of a spouse’s death is the last year in which the married couple can file married filing jointly. After the year of death, the surviving spouse files either as single or if there are dependent children, as a qualifying widow or widower. Qualifying widow(er)s retain the tax benefits of joint filing for up to two years after the year of the spouse’s death.

In addition to the shift from a married filing joint filer to a single filer, the surviving spouse’s marginal tax bracket may stay the same or even go higher even though his or her taxable income decreases. Some tax professionals call this the “widow’s/widower’s tax penalty.” The following example illustrates:

Example 1. Carl, a federal retiree, was married to Janet until Carl died suddenly in November 2021. During 2021, Carl and Janet had taxable income of $280,000, putting them into a 24 percent federal marginal tax bracket. During 2022, when Janet must file as single, her taxable income reduces to $175,000, putting her in a 32 percent federal marginal tax bracket for 2022.

                  A suggestion for minimizing the widow’s/widower’s tax penalty is for the surviving spouse to accelerate taxable income into the year of the spouse’s death. An example of income acceleration in the year of death would be the sale of financial assets held in non-retirement accounts (such as stocks, bonds, or open-ended funds) at a profit in order to take advantage of joint filing tax rates and marginal brackets while they are still available. If taxable income is expected to decrease in the year of death (for example the result of large medical expenses) that could provide more reason to accelerate income into the year of the spouse’s death.

“Step-Up” in Cost Basis for Capital Assets Held Outside of Retirement Accounts

Under current IRS rules, the estate of an individual who dies with assets held outside of retirement accounts (for example, real estate, stocks, bonds, open-end and closed-end funds) typically does not owe tax on their appreciation. When heirs inherit and sell these assets, they owe federal and state income tax only on the appreciation (growth) in the value of the assets after the original owner’s death. This restarting of the cost basis is called the “step-up” in cost basis.

In most states (those states that are not community property states), jointly held assets like a personal residence or investment account receive a 50 percent “step-up:” in cost basis after the first spouse dies. The following example illustrates:

Example 2. George and Sylvia bought a house in 2009 for $200,000. In 2022, George died when the house’s fair market value was $1.3 million. Sylvia’s cost basis in the house immediately after George’s death increases from $100,000 to $750,000 ($100,000 is 50% of $200,000 which is Sylvia’s original cost basis) plus $650,000 (half of $1.3 million which is the “step-up” in cost basis following George’s death).

Home-Seller’s Capital Gain Exemption

Surviving spouses who plan to sell their personal residence should watch the calendar. Couples filling married joint tax returns are eligible to exclude up to $500,000 of home value appreciation when they sell their personal residence. Widows and widowers also are eligible for this capital gain exclusion of $500,000 if they do not remarry and if they sell the principal residence within two years of their spouse’s date of death.

If the surviving spouse sells the principal residence more than two years after the day of death of their spouse, the maximum capital gain exclusion decreases to $250,000, the maximum exclusion amount for single tax filers.

Rolling Over Retirement Accounts

Surviving spouses are eligible to directly transfer inherited retirement accounts including traditional IRAs, Roth IRAs, TSP, 401(k), 403(b), or 457 qualified retirement plans, into their own names and accounts. Sometimes this rollover makes sense and sometimes if does not.

If a surviving spouse is younger than age 59.5 and directly transfers an inherited retirement accounts to their retirement accounts such as a traditional IRA with the intention to make withdrawals from his or her retirement account, then a 10 percent early withdrawal penalty will be imposed on withdrawals. On the other hand, if the deceased spouse had reached his or her required beginning date (RBD) in which required minimum distributions (RMDs) and the surviving spouse is younger than his or her RBD, then it makes good sense for the surviving spouse to transfer the inherited retirement accounts into his or her own retirement account. In so doing, the surviving spouse will not have to take any RMDs until he or she reaches his or her RBD. The following example illustrates:

Example 3. Paul, age 73, was married to Cynthia, aged 69 (a federal retiree) until June 3,2022 when Paul suddenly died. Paul was born before July 1,1949 and owned a traditional IRA. At the time of his death on June 3, 2022, Paul had not taken his traditional IRA RMD for 2022. Cynthia took Paul’s 2022 RMD in early July 2022 and then immediately directly transferred the balance from Paul’s traditional IRA into her traditional IRA. Because Cynthia’s RBD is April 1, 2028 (the April 1 following the year she becomes age 72, six years following the year Paul died) Cynthia will not have to take any RMDs from Paul’s inherited IRA until April 1, 2028.

Withholding and Estimated Taxes

In general, Individual tax filers must pay the IRS 90 percent of their anticipated total tax liability for the year by December 31 or soon thereafter. These tax payments are made via federal income tax withholding, federal estimated tax payments, or a combination of both.

If the spouse who died paid most of the withholding or estimated tax payments in order to meet the couple’s joint income tax liability, then the surviving spouse may need to make changes or risk tax underpayment penalties when the surviving spouse files his or her taxes for the year that the other spouse died. This could be especially the case if the deceased spouse died early in the year.

Filling a Federal Estate Tax Return

During 2022, the federal estate- and gift-tax exemption is $12.06 million per individual. The result is that very few individuals who die during 2022 will owe federal estate tax. Executors are not required to file a Federal Estate Tax Return (IRS Form 706) during 2022 if the value of the decedent’s estate is below the $12.06 exemption.

However, a surviving spouse may still want to file a Federal Estate Tax Return in the year of their spouse’s death (even though federal no estate tax is due) because then the surviving spouse can inherit their spouse’s unused estate exemption and add it to their own estate tax exemption. This is called federal estate tax “portability.”

Claiming the unused exemption may in fact be a wise move for the surviving spouse since there is talk in Congress of lowering the federal exemption to $6 million by the year 2026. The surviving spouse’s inherited real estate and investment assets may also appreciate significantly in the future.

The federal estate tax return is normally due nine months after the date of death. But in many cases, the IRS allows executors to claim the unused exemption for the surviving spouse up to two years after the date of death.

Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

Surviving Spouse's Finances

Surviving Spouse’s Finances