Financial planners often use the term Widow Tax to describe the situation where a surviving spouse inherits tax-deferred retirement accounts from a deceased partner, potentially leading to a substantial tax burden.
This issue primarily arises with tax-deferred accounts like Traditional IRAs, 401(k)s, and 403(b)s, which require Required Minimum Distributions (RMDs) to begin at age 73 or 75. RMDs are the IRS’s way of ensuring that retirees start paying income taxes on their previously tax-deferred savings.
RMDs are calculated by taking the balance of your tax-deferred account as of December 31 of the previous year and dividing it by the Distribution Period (DP) listed in the Uniform Lifetime Table.
RMD starting age
Uniform Lifetime Table
For example, if a taxpayer turned 75 in 2024 and their Traditional IRA balance was $750,000 as of December 31 of the previous year, their Required Minimum Distribution would be approximately $30,487 ($750,000 divided by 24.6).
It’s important to note that the IRS permits aggregating RMDs from multiple IRAs, but different rules apply to defined contribution plans.
Continuing with the Widow Tax, it’s clear that larger tax-deferred retirement account balances lead to higher RMDs, which are taxed as ordinary income. These increased RMDs can also impact other financial aspects, such as Medicare premiums.
Consider a common scenario involving a married couple with most of their savings in pre-tax retirement accounts. The graph below shows that as both spouses retire in 2035, they draw from their retirement accounts to cover their lifestyle expenses until they turn 75 and Required Minimum Distributions (RMDs) begin. Even though they may not need the extra income, they are compelled to withdraw more than necessary to meet RMD requirements, potentially pushing them into the 24%/28% (Pre/Post TCJA Sunset) ordinary income tax bracket.
This issue is exacerbated when the first spouse passes away—a likely scenario given the differences in life expectancies between men and women—resulting in an even greater tax burden for the surviving spouse, who must then file as “single” on their tax return.
Without Roth Conversions
What is the solution?
If time were on the example couple’s side, maximizing Roth contributions in the years before retirement is a viable option to consider. This allows the couple to build assets in the tax-free “bucket” and diversify the taxability of their various investment accounts (Taxable, Tax-deferred, Tax-free) while mitigating the potential burden that the Widow Tax poses.
If the example couple had time on their side, maximizing Roth contributions (Roth IRAs, Roth contributions to employer-sponsored accounts) before retirement would be a strategic option. This approach enables them to build assets in a tax-free “bucket” and diversify the taxability of their investment accounts (Taxable, Tax-deferred, Tax-free), helping to mitigate the potential impact of the Widow Tax.
Another option is to leverage the income valley between retirement and the start of RMDs. In this example, the couple could maximize the 22%/25% (orange) tax bracket up to the 24%/28% (blue) bracket by performing Roth conversions. This involves converting funds from tax-deferred retirement accounts to Roth IRAs, paying the taxes on the conversions with cash held outside the retirement accounts, so the full amount can be converted.
As shown below, converting an average of ~$124,000 per year over this ten-year income valley results in a ~23% reduction in total tax liability over both spouses’ lifetimes. This strategy keeps the surviving spouse from entering the 32%/33% tax bracket and leaves them with substantial Roth IRA assets that can be passed to heir(s) tax-free.
With Roth Conversions
This example highlights the effectiveness of Roth conversions in mitigating the Widow Tax. However, the benefits of conversions can be diminished if the couple lacks sufficient cash to cover the additional taxes each year. As more Baby Boomers and Gen X retirees face this issue, it’s crucial to consider this strategy to avoid paying taxes on the accounts they’ve spent a lifetime building.