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Tax Planning for Widowhood (or Widowerhood)

Your marginal tax rate (and, in many cases, how you expect your marginal tax rate to change over time) is a critical factor in tax planning decisions.

One thing that married couples often fail to consider in their planning is that, in the majority of cases, after one spouse dies, the widow/widower’s marginal tax rate will be greater than the marginal tax rate that the couple faced in the years immediately prior to the first spouse’s death.

Unfortunately, there is of course no way to know when widowhood will start or how long it will last. I’ve found it challenging to even determine how long widowhood lasts on average. I’ve seen figures from 8 years to 15 years quoted by reputable sources. Regardless, even 8 years is a considerable length of time and merits inclusion in tax planning.

Why Does Marginal Tax Rate Increase When One Spouse Dies?

After one spouse dies, the surviving spouse (starting in the following year, when they would have to begin filing as single) is left with smaller tax brackets. The 10% and 15% tax brackets are exactly half the size for single people that they are for married couples filing jointly. And the standard deduction and personal exemption of the surviving spouse are half of the amounts that the couple used to receive.

As far as income, there is typically a reduction when one spouse dies, but that reduction is typically insufficient to counteract the smaller exemption, standard deduction, and tax brackets. Social Security, for instance, does fall when one spouse dies, but the reduction is usually less than 50% (because if the spouse with the higher retirement benefit dies, the surviving spouse can claim a widow/widower benefit that’s equal to the deceased spouse’s retirement benefit). And investment-related income doesn’t typically decline at all when one spouse dies.

How Does This Affect Tax Planning?

This foreseeable increase in marginal tax rate after the death of one spouse is important because it affects decisions in which you have to compare your current marginal tax rate to the marginal tax rate you expect to have in the future. Specifically:

  • It is a minor point in favor of making Roth contributions (as opposed to tax-deferred contributions) during working years,
  • It is a significant point in favor of prioritizing retirement spending from tax-deferred accounts (as opposed to Roth accounts) while both spouses are still alive, and
  • It is a significant point in favor of doing Roth conversions while both spouses are still alive.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Investing Blog Roundup: Employer Stock in Your 401(k)

No matter how confident you are in your employer’s prospects, it’s generally a bad idea to hold a significant portion of your portfolio in your employer’s stock, if you have a choice in the matter. As Ron Lieber reminds us this week, investing heavily in the stock of your employer puts you in a position where not only your income but also your savings are dependent upon the results of one company.

Investing Articles

Other Money-Related Articles

Thanks for reading!

Is a Roth Conversion a Good Idea?

A reader writes in, asking:

“Regarding Roth conversions, is it worth it to convert, putting yourself in pretty high tax brackets if you have a lot to convert? Second is it worthwhile to do some converting when the result would likely still leave you with heavy RMD’s and 85% of SS taxed, nullifying some of the better reasons to convert?”

In the simplest situation — in which a person has only tax-deferred and Roth accounts — it usually only makes sense to do a Roth conversion if your marginal tax rate on the conversion is lower than you expect your marginal tax rate to be at every point in the future. (Otherwise, you could wait until the point at which you do have the lower tax rate and do the conversion then.)

Even with this simple situation, however, there are three additional points to keep in mind.

First, at least in theory, this analysis should be done dollar-by-dollar, because converting isn’t an all-or-nothing question. For example, if you have $500,000 in a traditional IRA, it may make sense to convert some of it. But after you’ve already converted a certain amount this year, you reach a point where your marginal tax rate on additional conversions is higher (e.g., because you’re in a higher tax bracket or because you reach a point where additional income would reduce/eliminate your eligibility for a certain tax break), so the math changes for additional conversions.

Second, you must include any applicable penalty when figuring the marginal tax rate on the conversion. For example, if you have $100,000 in a traditional IRA and you move $85,000 to a Roth IRA and $15,000 to your checking account in order to use it to pay the tax on the conversion, that $15,000 would count as a distribution and could be subject to the 10% penalty if you’re under age 59.5.

Third, as we’ve discussed here on several occasions, your marginal tax rate is not necessarily the same as your tax bracket. (It’s super common, for instance, for retirees to have a higher marginal tax rate than the tax bracket they’re in, due to the way in which Social Security is taxed.)

What if You Have Taxable Accounts As Well?

With taxable accounts in the mix as well, the analysis becomes much more complicated. In short, having money in taxable accounts typically makes Roth conversions more appealing, because you can use that taxable account money to pay the tax on the conversion, rather than having to siphon off some of the IRA assets to pay the tax.

As a result, if you have non-retirement-account assets with which you could pay the tax, Roth conversions typically make sense even if you expect to have only the same marginal tax rate in the future as you have right now. In fact, they can even make sense in some cases in which you currently have a higher marginal tax rate than you expect to have in the future — because the advantage that comes from tax-sheltering more of your assets may outweigh the disadvantage of paying a (relatively) high tax rate on the conversion.

In cases in which your tax rate on the conversion would be higher than the marginal tax rate you expect to face in the future, some of the factors to consider when deciding whether to convert or not would include:

  • How much higher is your current marginal tax rate than the marginal tax rate you expect to face in the future? (The greater the difference, the more appealing it becomes to wait rather than do a conversion now.)
  • How long do you expect the assets be in the Roth account? That is, how long before you expect to spend the money? (The longer, the greater the savings from a conversion due to not having to pay tax on further growth.)
  • What rate of return would you expect for the assets in question? (The higher, the greater the savings from a conversion.)
  • Do you have sufficient cash on hand in taxable accounts to pay the tax (or, alternatively, assets in taxable accounts that have cost basis equal to or greater than their current market value)? If you would have to liquidate taxable holdings — and pay capital gains taxes in doing so — in order to raise cash to pay the tax on the conversion, that’s a point against the conversion.
  • How likely do you think it is that you’ll be leaving these assets to heirs? (In many cases, it’s actually tax-efficient to leave taxable assets to heirs, because the heirs would get a step-up in cost basis.)

As you can see, this isn’t a question to which you can calculate a definitive answer, because many of the factors are unknowable. As a result, you may find that it makes sense to take a middle-of-the-road sort of approach, in which you do relatively modest conversions each year (perhaps converting until you reach the top of your current tax bracket) and sometimes converting more in years in which your income (and therefore marginal tax rate) is lower or the market is down (thereby reducing the cost of a conversion).

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Investing Blog Roundup: Rebalancing Isn’t Easy

Over the last few weeks, I’ve repeatedly received questions (and seen similar questions on the Bogleheads forum) about whether it’s worth ditching international stocks entirely, given their poor performance over the last several years relative to U.S. stocks. In short, my answer is that that’s the opposite of what most investors should be doing right now. For any investor following a buy/hold/rebalance investment strategy, now is the time to be rebalancing into international stocks.

By definition, rebalancing means beefing up your allocation to the asset class that has performed the worst recently, in order to bring your overall allocation back in line with the original plan. For many investors, that’s not easy.

This week, Christine Benz has tips on how to rebalance when you’re feeling chicken:

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Thanks for reading!

Which Interest Rates Affect Bond Prices?

A reader writes in, asking:

“I understand that a bond’s price goes up when interest rates go down and vice versa. Do interest rates usually move together with all rates going up by roughly the same amount? And if not, which interest rate is it that determines bond prices? Federal funds rate? Treasury bond rates? Other??”

Firstly, interest rates do not move in lockstep. For example, if the yield on 1-year Treasuries goes up by 1%, you shouldn’t expect the yield on 10-year Treasuries to necessarily go up by the same amount. It might go up by more than 1%, it might go up by less than 1%, or it might not go up at all.

You can see this by looking at how yield curves change over time. For those who haven’t encountered yield curves before, they are charts that show the yields for bonds of various maturities. For example, the following chart shows the yield curve for Treasury bonds as of the beginning of this year.

YieldCurve

If interest rates rose and fell in lockstep, the yield curve for Treasury bonds would always have this exact same shape — it would simply shift up and down as rates move. But that’s not the case.

The following chart shows the Treasury yield curve as of the first day of business on each of the last 5 years. As you can see, the lines do not share exactly the same shape, because interest rates did not move in lockstep. As it turns out, over those five years, short-term rates moved around much less than longer-term rates.

YieldCurves

And the above chart only looks at Treasury yields. If we were to include yield curves for muni bonds or corporate bonds, we’d see even more diversity.

So Which Rates Affect Your Bonds’ Prices?

Imagine that you’re trying to sell your car. The price you’re going to be able to get for it will depend on what other sellers are charging for cars with the same characteristics (make, model, year, mileage, condition, etc.).

The same thing goes for bonds. If you want to sell a bond, it is the yield on other similar bonds that will determine the price that you’re able to get.

So, for example, if you own a Treasury bond with 5 years remaining until maturity, and interest rates on 5-year Treasuries rise, the market value of your bond will go down. (That is, in order to make your bond as attractive to a buyer as a new, higher-yielding 5-year Treasury would be, you would have to lower the price of your bond until it provides the same yield to the buyer as a new 5-year Treasury would.)

Or, if you hold a portfolio of highly-rated short-term muni bonds, the market value of your bonds will depend on what happens with interest rates for other highly-rated short-term muni bonds.

Investing Blog Roundup: Senate Tax Writers Want Your Input

I generally make a point to keep politics out of my writing, because I do not want to alienate anybody. (And I don’t intend to change that policy.) At the same time, many financial topics are important political issues. Kay Bell of Don’t Mess With Taxes has some information this week on how you can participate in the current tax reform discussion, if you’re interested.

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