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How to Avoid the ‘Widow Tax Trap’

Advisors are bombarded with information surrounding the advantages of a delayed Social Security claiming strategy. Most of this information provides some perspective on coming up with the “optimal” strategy to collect the maximum benefit amount and ensure the client’s income against living too long.

Although the various claiming strategies are attractive to improving a client’s lifetime income, the improved tax benefits that may be achieved over the long term by delaying the claiming age are equally important in the client’s overall long-range plan. Here are the tax benefits to a claiming delay and how you may consider their impact on your clients.

The Traditional Thought Process
Clients typically believed that taking Social Security at age 62 was a wise choice. The rationale for this often was “I’m not going to live long, so I need to grab my benefits before the system goes broke!” This also would allow the client to leave the retirement portfolio (I will call it an individual retirement account or IRA for the remainder of article) to continue its tax-deferred growth. This is a strategy that most clients believe is sound.

The Issue
Let’s assume the client does not need to withdraw any funds from the IRA because they are living on the Social Security income. The IRA portfolio should continue to grow tax-deferred. That sounds great on the surface, but the postponed distributions and increased IRA value will yield unintended consequences later in life.

When the client reaches age 70½, required minimum distributions (RMDs) will begin. When these start, the distribution as a percentage of the account is minimal (see Internal Revenue Service Publication 590 for distribution tables), allowing the IRA account to continue to grow on a tax-deferred basis.  

All this sounds fine until a spouse passes away. This will create a new financial planning problem that didn’t exist previously — the client’s change in filing status from “married” to “single.” This frequently leads to what we call “bracket creep,” with the surviving spouse actually jumping into the next federal marginal tax bracket. For 2015, married couples can have taxable earnings of up to $74,900 and be taxed at the 15 percent federal tax bracket, but the single filer is taxed at 15 percent to a maximum of only $37,450! After that, she jumps into the 25 percent marginal bracket and potentially could move to an even higher bracket.

Most estate and financial plans are structured so that the surviving spouse will be the primary beneficiary of the IRA portfolio. The surviving spouse will become the sole IRA owner and find herself as a single taxpayer subject to the single taxpayer income tax rate structure.

It gets worse! She will most likely “fail” the provisional income test on her Social Security benefit. Now 85 percent of her reduced benefit (she can keep only one Social Security benefit)  will be counted as taxable income and will likely be taxed at the 25 percent marginal bracket for the rest of her life. We refer to this problem as the “widow tax trap.”

This is the plan so many uninformed prospects are following without understanding the consequences of taking their Social Security early and leaving the IRA account alone. Advisors understand that taxes will need to be paid on the IRA one day. The question is: Who will pay the tax — the married couple, the now single person (widow or widower) or their beneficiaries? Let’s look at why a delayed claiming strategy may yield a better outcome.

The Solution
First off, delaying Social Security will result in about an 8 percent increase in annual benefit for each year of delay. This is a good reason to delay, but it’s not the only reason. We advise clients to delay Social Security so that we have “bandwidth” within the client’s tax planning to start a drawdown of the IRA for cash flow planning.  

Without the Social Security, clients do not need to worry about failing the provisional income test and paying taxes on their Social Security benefits. Without taking the Social Security, we will have more room within the plan to begin a “cash flow bridge” using the IRA account for the client’s cash flow needs. This allows clients to delay the onset of Social Security, enjoy the 8 percent increase in the benefit caused by the delay and, most important, begin reducing the value of the IRA portfolio. The client will use the IRA distribution ahead of age 70½ either to live on or possibly to begin converting some of it to a Roth IRA. The goal is to reduce the IRA portfolio value so that by age 70 1/2 the required distributions will be reduced and the Social Security income potentially will avoid the pitfalls of the provisional income test. This will result in a tax-free benefit to the client.

IRA distributions are counted toward the Social Security “provisional income test.” But if the IRA account value is reduced, the required minimum distribution will be lower because the account value has been reduced, impacting the RMD calculation. In addition, Roth IRA distributions do not count toward the provisional income test. Roth IRAs have no required distribution to contend with, and the distributions from the Roth will typically be income tax-free!

It is important to understand the tax benefits that can be accomplished for a client when you combine the delayed claiming strategy with an IRA distribution strategy. Managing the claiming strategy for Social Security — not only from a cash flow planning view, but from a tax planning view — may yield the best of both worlds for your client: income for life with improved after-tax cash flow and a tax-free legacy for the heirs.


Gregory B. Gagne, ChFC, is a 13-year Million Dollar Round Table member with four Court of the Table and four Top of the Table honors. He is founder of Affinity Investment Group. Contact him at [email protected] .

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