Taxes

Tax Issues to Consider When My Spouse Dies

By Chris Duderstadt

October 14, 2024

Tax Issues to Consider When My Spouse Dies


Key Points – Tax Issues to Consider When My Spouse Dies

  • Understanding Tax Bracket Management
  • Tax-Free Income as a Surviving Spouse
  • What Is a Step-Up in Basis?
  • Reassessing Gifting Strategies
  • 8-Minute Read

Tax Issues to Consider When My Spouse Dies

Whether it’s expected or unexpected, the death of your spouse can be a traumatic event that’s difficult to process. We’re not here to tell you how to grieve, but there are several other things that our team can potentially help you with in that tough situation. One of them is tax issues to consider when your spouse dies.

Filing Your Spouse’s Final Return

Before we dive into potential tax issues to consider for surviving spouses, let’s address what needs to be done for filing a decedent’s final tax return.1 The surviving spouse (or representative if the decedent was single) will simply need to note that their spouse is deceased. That’s the only notification that the IRS needs to document a decedent’s death. The filing deadline for the decedent’s final return is on Tax Day (typically April 15) unless an extension has been filed.

Becoming a Single Tax Filer

In the year of your spouse’s death, the surviving spouse is typically still able to maintain a married filing jointly tax status. It’s possible to continue to file jointly as a Qualifying Widower for two years following your spouse’s death if you have dependent children.2 However, it can be another tough reality for a surviving spouse to become a single tax filer in the tax year after their death. Let’s go through an example to highlight the potential issues to consider when becoming a single tax filer when a spouse dies.

If you and your spouse had $200,000 of taxable income for the 2024 tax year, that would put you near the top of the 22% tax bracket if you’re married and filing jointly. Even if your income is reduced following your spouse’s death, there’s a possibility you will still be in a higher tax bracket. Maybe your taxable income would amount to $150,000 following your spouse’s death. That would put you near the middle of the 24% tax bracket.

Tax Bracket Management

Remember that the U.S. uses a marginal tax system. As a single filer, all $150,000 wouldn’t be taxed at 24%. Your first $11,600 would be taxed at 10%. You would then accelerate through the 12% and 22% brackets. The top of the 22% bracket is capped at $100,525 for single filers (it’s $201,050 for married filing jointly). So, only $49,475 would be taxed at 24% as a single filer. Keep in mind that the next highest tax rate is 32%, so it’s important to understand how to manage the tax brackets.

We’d also be remiss if we didn’t mention that the current tax rates from the Tax Cuts and Jobs Act are scheduled to sunset after 2025.3 Unless Congress steps in, tax rates would revert to the higher rates of 2017 beginning in 2026.

Considering Roth Conversions

To effectively understand tax bracket management, it’s critical to be cognizant of how your different assets are taxed. While your paycheck is typically a significant portion of your income during your career, what income sources will you have in retirement and how will they be taxed?

If you and your spouse only saved to the traditional side of your respective 401(k)s, that retirement income will grow tax-deferred. That means that you aren’t required to pay taxes on that money until you take the money out of the account. Can you see how that could potentially lead to tax issues when your spouse dies? Again, it’s possible that you’ll be in a higher tax bracket after your spouse dies when you’re making those traditional IRA withdrawals.

In that scenario, it may make sense to consider doing a Roth conversion. You would be required to pay tax on the conversion, but the earnings and distributions generally grow tax-free under certain conditions.

You should also consider filing Form SSA-44 with Medicare to adjust Medicare IRMAA premiums down because of a spouse’s death. A Roth conversion in the year of a spouse’s death could subject you to IRMAA.

Learn more about considerations surrounding Roth conversions in our Roth Conversions Case Studies white paper.

Tax Issues When Spouse Dies

Roth Conversion Case Studies

Speaking of Tax-Free…

Determining how to get more tax-free income can be very appealing, especially as a surviving spouse. That’s one reason to consider carrying life insurance into retirement. Most life insurance death benefits are tax-free.

Let’s say that you and your spouse carry a life insurance policy on each other. If the policy is large enough to pay the taxes to convert an IRA to a Roth IRA when either spouse dies, the surviving spouse could be receiving a more substantial tax-free benefit.

Your Social Security Benefit Is a Different Story

Let’s shift gears from discussing life insurance death benefits to Social Security benefits and how they’re taxed. To determine what percentage of your Social Security benefits are taxable, you’ll need to calculate your provisional income. It’s a formula that takes 50% of your Social Security benefit and adds to it any other form of taxable income, including that of municipal bonds. Guess what form of income doesn’t factor into the provisional income formula? If you said, “Roth IRA distributions,” you’re correct.

If you and your spouse’s combined taxable income is less than $32,000, your Social Security spousal benefits won’t be taxed. However, if your combined taxable income is between $32,000 and $44,000, up to 50% of your benefits will be taxable. And if your combined income exceeds $44,000, up to 85% of your benefits will be taxable.

When a spouse dies, the surviving spouse keeps the higher of the couple’s benefits. That’s part of why it’s so critical to coordinate claiming strategies with your spouse. The longer you wait to begin claiming your Social Security benefits (you’re first eligible at 62), the larger your benefit will be.

If you’re married and are thinking about when to claim Social Security, your spouse should be at the heart of that decision. If you die before your spouse, don’t you want your spouse to be OK financially? Taxes are one of the leading wealth-eroding factors for people in retirement, so we want to make sure you’re maximizing your Social Security benefits. Download our Tax Reduction Strategies guide to learn more Social Security claiming strategy and tax mitigation considerations.

Tax Issues When Spouse Dies

Tax Reduction Strategies

Do You Have a Step-Up in Basis on Inherited Taxable Accounts, Real Estate, or Hard Assets?

Another important tax issue to consider when your spouse dies is the potential step-up or step-down in basis on inherited taxable accounts, real estate, and hard assets. Before we explain what a step-up in basis is, you first need to understand what the cost basis was. That’s the purchase price of the asset, including any taxable re-investments.

For example, if you hold mutual fund investments, re-invested dividends and capital gains distributions are added to the basis. You’ll have a capital gain if the fair-market value is more than the cost basis. In that instance, you would pay tax on the gain. Assets acquired through inheritance are considered as meeting the long-term capital gain holding period.

A Step-Up in Basis Example

Keeping track of cost basis isn’t always easy, especially when it comes to things like family heirlooms that have substantially appreciated. For example, let’s say your great-grandfather paid $40 for a clock. It eventually was inherited by your grandparents and your parents before you inherited it. However, you decided that you would prefer to sell the clock at its fair market value of $4,000.

In situations like that in which you can’t substantiate the cost basis, that basis is automatically $0. So, does that mean you would need to pay tax on the $4,000? The answer to that is no because of the step-up in basis provision. The cost basis of the clock would receive a step-up to its fair market value of $4,000, so there would be no capital gain to pay. However, it’s important to note that since the clock could be considered as a collectable, it may be subject to the higher 28% capital gains rate without the step-up in basis.

We do want to reiterate that a step-up in basis is only possible on inherited taxable accounts, real estate, or hard assets. It does not apply for inherited IRAs, 401(k)s, and other retirement accounts, including non-qualified annuities. In non-community property states, jointly owned non assets will receive a 50% step-up.

If possible, in non-community property states, prior to an eminent death that is a year or more away, reposition assets with unrealized gains in the name of the spouse with the lower life expectancy to capture the most step-up in basis. Assets with unrealized losses should be held by the spouse with the longer life expectancy to avoid a step-down in basis. Recognized losses should be done by the spouse with the longest life expectancy to avoid losing any capital loss carryforwards.

Additional Medical Expenses

If you’re reading this as a surviving spouse, hopefully your spouse passed away peacefully and didn’t require substantial medical expenses toward the end of their life. However, there is a potential opportunity to diminish the impact of those expenses. If the medical and dental expenses for you, your spouse, and dependents exceeds 7.5% of your adjusted gross income, you might be able to deduct those expenses if you itemize them.4

Reassessing Gifting Strategies

Finances aside, it can obviously be difficult to live life to the fullest after losing your spouse. How can you honor your late spouse moving forward? Did they have any charities and/or causes that were near and dear to their heart? It’s important to make sure that the charitable giving that you and your spouse did before your spouse’s death will still work within your financial plan.

Building generational wealth can also be even more meaningful to people during their final days. We also want to make sure that you understand that wealth transfer doesn’t need to wait until you or your spouse dies. If you want to gift assets to your kids and/or grandkids, consider giving it to them with warm hands rather than cold hands. And don’t forget what we mentioned earlier about the taxation of different assets as you’re considering wealth transfer strategies. You and your beneficiaries need to understand the rules for taking distributions from inherited accounts.

Updating Your Beneficiaries

Speaking of beneficiaries, it’s critical to update beneficiary designations after major life events, such as the death of a spouse. Keeping your beneficiaries up to date is a crucial component of estate planning. We understand that thinking about what will happen to you and your spouse’s assets once you’re gone might not be the most fun thing to talk about, but it’s important to communicate your wealth transfer goals to your beneficiaries.

Additionally, you should notify your pension plan provider of your spouse’s death. Some public retirement systems allow the survivor to change from a survivor benefit to a life-only benefit, providing a higher pension income to the pensioner going forward.

Again, the death of a spouse can obviously be a traumatic event. It can potentially become even more difficult if your family is at odds with each other about receiving an inheritance due to beneficiaries not being updated on an estate plan.

Working with a Team of Professionals

As you can hopefully see, tax issues and estate planning issues are typically intertwined when it comes to wealth transfer. Trying to deal with those various issues on your own can potentially be overwhelming, especially after the death of a spouse or other family member. That’s one of many reasons why we implore people to work with a team of financial planning professionals.

At Modern Wealth, we have CFP® Professionals, CPAs, CFAs, estate planning specialists, risk management specialists, and company retirement plan experts that work with each other on behalf of our clients. Let’s plan for those potential tax issues that could arise when you or your spouse dies so that the surviving spouse can keep their hard-earned wealth instead of seeing more of it go to the IRS.

To learn more about tax issues to consider when a spouse dies and how our team goes about planning for them, start a conversation with our team below.

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Remember that it’s not about what you and your spouse make, but what you keep. We’re ready to build you a financial plan that’s tailored to your goals and that can withstand wealth-eroding factors such as taxes.


Resources Mentioned in This Article

Downloads

Other Sources

[1] https://www.irs.gov/newsroom/how-to-file-a-final-tax-return-for-someone-who-has-passed-away

[2] https://www.investopedia.com/terms/q/qualified-widow-or-widower.asp

[3] https://taxfoundation.org/blog/tcja-expiring-means-for-you/

[4] https://www.irs.gov/taxtopics/tc502


Investment advisory services offered through Modern Wealth Management, Inc., a Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management a Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.