Tax Gotchas at the 4 Stages of Retirement—Including the SECURE Act

Jul 16, 2020 / By Debra Taylor, CPA/PFS, JD, CDFA
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Clients may think the financial work is done and it’s time to relax when they hit retirement—don’t let them get blindsided by these four tricky tax situations that could detract from a long and enjoyable third act.

Most couples think that, by moving into retirement, the hard work is done. But the federal government ensures that’s never the case! There are plenty of tricky tax rules and regulations that make handling finances in retirement a burden, and not knowing them can eventually cost millions of dollars both for the client, and their children.

We are going to walk through the life of a hypothetical client couple in four stages, using a base case for comparison. First, we look at a typical married couple, which has the most tax-advantaged structure. Second, as our married couple ages, required minimum distributions (RMDs) will kick in at 72, creating an additional tax burden. Third, one spouse will eventually pass, in our case the husband, meaning the wife is left single and subject to the Widow’s Penalty. Fourth, the remaining spouse will ultimately pass, and the remainder of the IRA (which the surviving spouse was likely told not to spend down) will be left to the children, causing additional tax headaches thanks to the recently enacted SECURE Act.

Base Case: A couple, married filing jointly at the age of 71, with no RMDs

  • $2,000,000 traditional IRA
  • $1,000,000 taxable account
  • Returns: 6% per year
  • Social Security: $45,480 for husband; $32,000 for wife
  • Dividend income: $20,000 every year
  • Long-term capital gains: $25,000 every year

Let’s see how their tax picture looks prior to RMDs.

Stage 1: Married filing jointly at age 71

  • Taxable income: $57,379 (includes partial taxation of Social Security)
  • Total tax: $1,238
  • Marginal bracket: 10%
  • Additional annual IRMAA surcharge: $0

As you can see, the couple has a total taxable income of $57,379, meaning they are in the 10% marginal tax bracket and their total tax burden amounts to $1,238. Only $39,779 of their Social Security benefit of $77,480 is taxable. They’re not yet age 72, which means they don’t have to take any required minimum distributions, or RMDs, and there is no additional surcharge on top of their IRMAA premium. Right now, their tax situation is quite simple, but that’s going to change in the next year when they turn 72.

Once they turn 72, they start collecting RMDs, which triggers all kinds of additional taxes.

Stage 2: Married filing jointly at age 72

  • Taxable income: $159,661 (includes RMDs of $75,471)
  • Total tax: $23,358
  • Additional tax from Stage 1: $22,120
  • Marginal bracket: 22%
  • Additional annual IRMAA surcharge: $840 per person (includes Part B and Part D)

Under the SECURE Act, RMDs can be delayed until age 72. As the couple turns 72, their taxable income almost triples, increasing from $57,379 to $159,661 in the span of just one year simply as a result of the RMDs! With that increase in income comes a $22,120 increase in their tax burden, amounting to a total tax of $23,358. For example, now $67,176 of their Social Security is taxable, whereas only $39,779 of Social Security was taxable prior to taking RMDs. As a result, the couple is pushed into the 22% marginal tax bracket and incurs an additional IRMAA surcharge of $840 per person for the year ($5140.80 per year in total Medicare). As you can see, although the income increase is obviously appreciated, it comes with a nasty tax burden—which is often not anticipated.

On to the next stage: one of the spouses will eventually pass, likely the husband. Here we assume he dies at age 78.

Stage 3: Widowhood at age 78

  • Taxable income: $185,734 (includes RMDs of $111,448)
  • Total tax: $34,127
  • Additional tax from Stage 2: $10,769 (due to Widow’s Penalty)
  • Additional tax from Stage 1: $32,889
  • Marginal bracket: 24%
  • Additional annual IRMAA surcharge: $4,656 (includes Parts B and D)

It’s never fun to plan for death, but the federal government makes sure that the death of a spouse is always on your mind—and this stays true regarding taxation. The Widow’s/Widower’s Penalty, as it’s called, is the tax penalty often incurred by the death of a spouse. Typically, the remaining person’s total income doesn’t drastically change, because the couple (and eventually the widow) is typically retired and living off savings, investment income, and potentially Social Security at that time of their lives. However, tax brackets are more forgiving towards those married filing jointly compared to singles, so the widow is in effect forced to pay a tax penalty for her husband’s death.

As you can see above, the taxable income actually increases slightly after her spouse’s death—however, she is now forced to register as a single filer, meaning she is in the 24% tax bracket, and incurs $10,769 more in taxation than she would have if she were still married filing jointly. The IRMAA surcharge also jumps as a result, increasing from $840 to $4,656 per year, for an annual total of $6,392.40 in Medicare charges.

Now, let’s say that our widow increases her income slightly at age 78, to allow for additional gifting or medical or long-term care expenses.

Modified Stage 3: Widowhood at age 78—Widow’s Penalty plus an additional $50,000 distribution from the IRA

  • Taxable income: $235,734 (includes RMD of $111,448 and additional $50,000 IRA distribution)
  • Total tax: $48,867
  • Additional tax from Stage 3: $14,740 (due to additional $50,000 distribution)
  • Additional tax from Stage 2: $25,509 (due to Widow’s Penalty)
  • Additional tax from Base Case: $47,629
  • Marginal bracket: 32%
  • Additional IRMAA surcharge: $4,656 (includes Parts B and D)

Now, take Stage 3, but add in an additional $50,000 IRA distribution taken by the widow. This increases taxable income to $235,734 and pushes the widow from the 24% marginal tax bracket into the 32% bracket, meaning the total amount of tax increases by $14,740 to become $48,867, compounded by the Widow’s Penalty. Clearly, even a seemingly small additional distribution of $50,000 can incur thousands in additional taxes.

Now, let’s see what happens when our widow eventually passes—but without the proper planning.

Stage 4: Wife dies at age 90—the $3.2 million IRA passes to beneficiaries

Once both spouses have passed, the IRA is transferred to the beneficiaries—in this case, the two children. The SECURE Act forces each child to deplete the entire IRA account by the tenth year, and, if the inherited IRA is traditional, which in this case it is, they must pay income tax on it.

Consider that, if a large enough traditional IRA is inherited, the beneficiaries might lose almost half of it to taxes.

In this case, the IRA is a traditional IRA, now worth $3.2 million. Splitting this up between the two kids, a $1.6 million balance must be withdrawn by each beneficiary within 10 years of their mother’s passing. This can potentially equate to an extra $160k+ in income per year if they choose to spread the distributions out for the length of the 10-year period.

Keep in mind that the account will still be growing once inherited, so actually, more than $160k will have to be withdrawn each year by each of the two kids. They could also choose to withdraw the entire amount in one year, but this would push the beneficiaries into the highest tax bracket on its own for that given year, regardless whether they are single or married filing jointly.

To have a $0 balance by the end of year 10, the heirs would have to withdraw about $205,000 per year, assuming 6% growth. As said before, assuming $150,000 in income on top of the $205,000 withdrawals, the beneficiary is forced into the 32% bracket if married filing jointly (assuming no other income), and the 35% bracket if single (assuming no other income). As you can see, under the SECURE Act, a large traditional IRA balance can have daunting effects on the beneficiaries of the account.

We have written earlier on the need for tax management for clients with large traditional IRA balances. By simply planning ahead, much of the headache (and costs) resulting from these tricky tax laws can be avoided, and anywhere from tens of thousands to millions of dollars can potentially be saved in the process.

Research assistance was provided by Cecilia Taylor.

Debra Taylor, CPA/PFS, JD, CDFA, is the principal and founder of Taylor Financial Group, LLC, a wealth management firm in Franklin Lakes, N.J. Debra has won many industry honors and is the author of My Journey to $1 Million: The Systems and Processes to Get You There, a book about industry best practices. She is also a co-creator of the Savvy Tax Planning program.

Comments

You jumped the gun when the spouse dies at 78. In the year of death you can still file a joint return. The next year you file as a qualifying widow, which is the same as jointly. After that, you file as a single. Additionally, I know it's an article about tax gotchas, but a 78 year old with a 2.5-3 million dollar IRA, likely a paid off house, likely an insurance payout in the bank, plus an income stream of 185k, having to pay 30% tax on an additional 50K distribution, does not elicit much outrage or sympathy.
I apologize if I left that point intentionally ambiguous, as the objective was to illustrate the increasing tax burden at the various stages, and excluding a year or so doesn’t detract from the damage that high taxes create for a widow. Regarding your second point, paying taxes and the pain that goes along with it is in the eyes of the beholder (or the payer, as the case may be). Again, taking it out of context doesn’t do justice to the ultimate surprise to many clients and the harm that is created, as you ignore the SECURE Act and other pitfalls that wait.

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