What is known as the IRS survivor’s penalty, and is there anything that can be done to provide for a surviving spouse as we age? The “survivor’s penalty” is the likelihood that a surviving spouse will face higher federal and state taxes when simply changing their status from “married filing jointly” to “single” on tax returns. Is it possible to accomplish prudent domestic tax planning or transactional planning to minimize the impact of the survivor penalty before the passing of a spouse?
According to recently published data from the Centers for Disease Control and Prevention, the average period of survivorship for those approaching retirement is 3.5 to 5 years. The CDC’s “Provisional Life Expectancy Estimates for 2022” (Report #31, Nov 2023) shows women are more likely to survive their spouse and will live (on average) 5 years longer. The tax consequences remain regardless of which partner survives.
One piece of good news is the surviving spouse is they will be able to file using the tax status of “married filing jointly” for the tax year of the passing of their spouse, unless they remarry prior to the end of that tax year. Surviving spouses will have smaller standard deductions and higher marginal tax rates once their filing status changes to “single.”
In addition, a surviving spouse usually inherits their deceased partner’s assets and retirement accounts. One of the first challenges a surviving spouse will often encounter is the required minimum distribution and/or withdrawal rules in these inherited retirement accounts. There are many rules to be aware of and to plan for.
The beneficiary of an inherited retirement account such as an IRA is usually required to take some form of distribution from that account by the final day of the year of their spouse’s passing (December 31). There will be several issues associated with the rules for minimum distribution amounts and whether Required Minimum Distributions (RMDs) have already begun.
Many of these spouses will be required to withdraw all funds within a 10-year period of time, generating additional tax consequences as well. The IRS survivor’s penalty is associated with the requirement to pay a higher tax rate on forced deductions based upon a “single” tax filing status. The problem get’s bigger as the balance in the inherited account grows larger.
Is it possible to reduce the impact of the IRS survivor’s penalty?
The simple answer is “yes.” However, you should begin conversations with your tax and estate planning attorney as soon as possible, preferably before the passing of either spouse. An effective estate and transactional plan will structure retirement vehicles and assets in a manner that provides maximum flexibility for several important factors, including when and how taxable income is realized and how assets and income are structured to maximize protection while reducing the impact of taxation.
How is the portfolio presently structured? What rules must you be aware of with regard to inherited retirement assets such as IRA to avoid IRS penalties and increased tax rates? How can the “basis” of inherited assets be increased (known as a “step-up in basis”) to reduce the impact of capital gains in the future? What are the best strategies to reduce taxation on required distributions and the conversion of assets in your portfolio?
The passing of a spouse is one of the hardest challenges many of us will face. The impact of the IRS survivor’s penalty and a potential increase in associated state taxes is a genuine issue. A visit with an experienced estate planning and tax attorney can provide you with sound advice and counsel as well as peace of mind. Life is going to be a bit different. It only makes sense to protect the assets you’ve received and reduce the impact of taxation when you choose to access them.
We invite you to learn more about the integrated tax, legal, accounting and business consulting services of Allen Barron and contact us or call today to schedule a free consultation at 866-631-3470.