This is a guest blog written by Justin W. Smith, founder of the insurance consulting firm, Balanced Strategies, LLC. Smith is a guest blogger for The Cavalier Strategy that focuses his research on using life insurance to guard against the biggest threats to wealth preservation. Smith is also a general agent at Cavalier Associates.
Earlier this year, I wrote about the need for considering tax diversification in retirement planning. The tax-erosion of retirement income is something that every retirement planner needs to take seriously.
Building on that theme, planners must consider the potential tax-effects of the first spouse passing away during retirement, leaving the surviving spouse with unintended consequences that can dramatically affect their lifestyle.
No matter what stage of life, there is nothing that can prepare one for the loss and emotional maelstrom that comes with losing a spouse. With so much to go through, accept and adapt to, the last thing that anyone wants to be thinking about are the impending income tax consequences.
change in filing status
The Tax Code allows for a filer to retain a Married Filing Jointly status for the tax year in which a spouse passes. However, the following tax year will require a change in filing status.
Without proper planning, the realities of the filer status change that happens within two years of the first spouse passing will surely set in, and it can wreak further havoc.
The change in filing status can have rather onerous tax consequences on the surviving spouse’s income, causing the surviving spouse to receive a significant reduction in after-tax income.
Consider a retired couple, each age 68, taking the following distributions:
- $19,000 per year from a 401k
- $22,000 per year from an IRA
- Joint Social Security benefits of $32,000 per year.
Their total retirement income is $73,000.
When the spouse passes, the financial consequences for even those who have planned for retirement can be dramatic. Going forward, the surviving spouse will only receive one Social Security benefit. In this example using the 68-year-old couple, that translates to a 34% reduction in Social Security income, from $32,000 while married to $21,000 as a widow.
To make up for the loss of Social Security income, the widow must take larger distributions from both the IRA and 401k in order to receive the same total income of $73,000.
Because of changes in the source of her income, however, the amount of Social Security income excluded from tax has been reduced from 50% to 15%. And the pain doesn’t end there.
Now, as a single-filer, her standard deduction (assuming no itemized deductions) has been cut in half, and she has only one personal exemption.
In this example, despite her total income remaining equal to what it was while her husband was alive, her taxable income has increased by over 58%.
Under the 2013 income tax tables, the joint-filing couple would have had a marginal Federal income tax bracket of 15%. With the change in filing status the following year to Single filer, the same $72,000 income will result in a 25% marginal Federal tax bracket (assuming the same tax brackets remain in place).
In this simple example if the widow is a California resident, the change in filing status results in a combined Federal and state tax increase of 158%. The widow’s after-tax income is reduced by 13%, which for some can mean a material change in lifestyle.
IRA and cash-value life insurance alternatives
So how can you avoid this kind of planning pitfall? Consider the planning vehicles that offer the greatest tax-leverage.
While there is tremendous influence encouraging workers to contribute to 401k’s on a pre-tax basis, it may be wise to consider Roth IRA’s and cash-value life insurance in addition or possibly as an alternative (you probably don’t want to skip an employer match).
Roth IRA’s and cash value life insurance are phenomenal tools for retirement planning. They enjoy tax-free growth and tax-free income in retirement (if the life insurance policy is properly structured and managed). Life insurance provides the further flexibility and leverage of the tax-free death benefits paid to beneficiaries.
So, imagine how the couple I have described could have benefited from the use of life insurance policies in their retirement plans.
First of all, if they had allocated a portion of their retirement investment dollars into accumulation-oriented life insurance policies, those funds would have grown tax-free.
Well-constructed policies could have produced tax-free income in retirement for both the husband and wife. That would have lowered their tax liability versus the exposure of all of their non-Social Security retirement income to tax.
Additionally, with lower taxable income may come a lower tax bracket. The amount of Social Security retirement income that can be excluded from tax could end up being much more favorable for the couple both while married and after the first death.
Lastly, and perhaps of greatest importance, would be the tax-free death benefit that would be payable at the first spouse’s death. The liquidity would allow the surviving spouse flexibility to do things that are needed to be done financially as she adapts to the many life changes.
One more thing to consider when contemplating the evaluation of life insurance as a proper retirement planning vehicle is the ability to incorporate long term care riders.
The couple I outlined would be in real financial peril if either triggered the need for long term care. At $73,000 of retirement income, they would not have the ability to pay the full cost of just one of them needing full time care given today’s costs. They’d almost certainly be liquidating assets such as a home to fund those expenses.
The inclusion of long-term care or even chronic or critical illness benefits in a life insurance policy give a retirement plan that much more potential to be successful.
I am not advocating that life insurance policies should be recommended instead of 401k’s Roth IRA’s, Pensions or Traditional IRAs. I am suggesting that incorporating the use of properly designed life insurance in retirement planning can yield an outcome that is much more secure and guards against the potential erosion of income by taxes.
Planning with the end in mind – and protecting against all potential threats – is a key part of retirement planning.