According to the US Census Bureau, approximately 800,000 people are widowed each year in the United States, and “nearly 700,000 of them are women who lose their husbands.”
One of the greatest economic challenges for a large portion of widows in America is higher income taxes when their spouse passes away.
It seems counterintuitive that this could happen, generally in conjunction with a reduction of income. Specifically, once their spouse passes away, their income from Social Security will decrease (the surviving spouse only gets to keep the larger of the two Social Security checks), and if their deceased spouse had a pension, it will likely be reduced, or it may even go away altogether for the widow.
Now, there are multiple reasons why taxes go up for widows. One such reason is the reduction in their personal exemption and standard deduction, which automatically increases their taxable income approximately $11,600 (2016). On top of that, single income tax bracket caps are lower, so advancing to the next highest tax bracket happens much quicker.
The largest culprit for creating the higher uncontrollable taxes for widows are Required Minimum Distributions (RMDs). As most retirees know, at age 70 ½ they are required to take out a minimum distribution each and every year from their qualified accounts such as IRAs, 401(k)s, 403(b)s, thrift savings plans, etc. Whether they need or want them, this applies to the surviving spouse.
What has historically been a problem for widows can now be controlled with proper planning prior to their spouse passing away. This is done by using what we describe as a R.I.S.T. “Retained Income Spigot Trust” (IRC Section 664).
How the trust works is that prior to the spouse passing away, the trust is created, and then the beneficiary designation form for the spouse’s qualified accounts are changed to make the trust the beneficiary.
Once the spouse passes away, the value of the qualified accounts is then deposited into the R.I.S.T. The widow then can decide yearly if she wants 0%-5% of the account for her life. The decision on the amount withdrawn may be part of needs or strategic income tax reduction planning, and can be controlled from year to year. Keep in mind that whatever amount of the 5% she chooses not to take will accumulate for future distribution if ever needed.
So the question normally becomes, “What happens when the widow passes away?” The answer is that it depends on the pre-planning. The income can continue to the heirs for 20 years or for life, depending on the planning decisions that are made.
There are some other considerations for the setting up a R.I.S.T. Recently, legislation has been proposed to eliminate the planning tool referred to as “Stretch IRA’s”. This proposal is expected to pass in the next few years. This would eliminate the ability for heirs to “stretch out” the distributions of the IRA over their lifetime with the proposal suggesting a maximum five-year payout. In addition to that, the Supreme Court ruled in June 2014 that an inherited IRA (other than for a surviving spouse) is not protected from creditors.
The creation of the R.I.S.T. would be beneficial for the heirs since the account is protected from creditors. The income can be paid out (stretched) over 20 years or for life. The annual amount paid out at the discretion of the heir(s) is 0-5%. If there are any concerns as to whether one or more of the widow’s heirs might take all the money out and just “blow it”, this can be remedied by the trust payout being restricted to the maximum yearly distribution of up to 5%, plus any retained accumulation.
As you can see, the R.I.S.T. allows future widows to take control of their tax liabilities and can even help their heirs as well, as long as there is pre-planning that occurs.
By Don Rasmussen
Don Rasmussen, a partner in Walters CPA Group, PLLC, is a member of Ed Slott's Elite IRA Advisor GroupSM and a Certified Tax Coach (CTC). He is a seasoned tax reduction strategist having worked with individuals, businesses, and charities around the United States for over 28 years. He has guided them to make informed decisions, avoid costly mistakes, maximize their tax efficiency, lower their taxes, and find money falling through the cracks in their current tax planning. Don is a sought after speaker on tax & financial issues and has been a featured contributor to Fox Business on tax issues. www.walterscpagroup.com.