The prosperous couple—we’ll call them Bill and Mary, though those aren’t their real names—thought they had done everything right. Bill had maximized his Social Security benefit by waiting until age 70 to begin receiving it; Mary was taking her spousal benefit, because it was larger than the benefit she could claim on her own. They had investments earning dividends and interest, and they were also collecting half of the income from a property that Mary, age 67, co-owned with her mother, age 87. They assumed that when Mary’s mother passed, they could add the other half of the rental income to their cash flow.
But Mary died unexpectedly at age 68, and the full amount of the rental income began going to her mother, who was now the sole owner of the property. Also, Mary’s Social Security checks ceased with her death. Bill was faced with a sufficiently reduced income that he had to sell their family home and move to a less expensive state, where he would be able to live within his means.
Clearly, Bill and Mary had failed to take fully into account the financial implications of Mary’s untimely passing. Though their will was in order, they would have benefited by paying more attention to the way all their assets were titled.
The problem can also run the other way: sometimes the surviving spouse is left with too much money, which throws them into a much higher tax bracket, since they must now file as single, rather than married filing jointly.
One of the most important parts of a sound financial plan is how it accounts for the possibility of the unexpected. Especially when a spouse dies, the financial implications—not to mention the emotional ones—can run in some surprising directions.
It’s important to carefully evaluate not only the adequacy of life insurance coverage and how assets are titled, but also to look at the character of the assets. For couples with large balances in tax-deferred accounts like traditional IRAs, 401Ks, and other tax-favored plans, it can make sense to begin converting to Roth accounts in advance of retirement. Though this necessitates paying taxes now on the amounts converted, it can often save money on future taxes for the eventual beneficiary, especially since Roth accounts do not require distributions in retirement, which is when a suddenly single person can often find themselves in a higher tax bracket than when their spouse was alive.
For couples with significant investment accounts, it can also be important to make timely decisions about offsetting investment gains with losses. This action must be taken in the same calendar year as the death of the spouse, however, so time is often of the essence. For example, if, at the time of a spouse’s death, the couple’s investment account has a holding with an unrecognized $10,000 loss, and another with an unrecognized $10,000 gain, it may make sense to recognize both, allowing the loss to completely offset the gain. If desired, the “winning” asset can even be re-purchased, thus re-setting the cost basis and potentially avoiding a capital gains tax bill in the future. But the loss must be claimed in the same calendar year as the death of the spouse. According to IRS Revenue Ruling 74-175, only the taxpayer who sustains a capital loss is entitled to take the deduction (ie., it cannot be transferred to the taxpayer’s estate), and it must be taken on the final tax return filed for that taxpayer.
At Mathis Wealth Management, we specialize in helping our clients make smart, timely decisions to save on taxes and to maximize income for the future. If you would like to learn more, please contact us.