The financial effects of losing a spouse

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By Rocky Mengle
Posted on August 16, 2021

The death of a spouse is one of the most difficult things imaginable. Besides the emotional toll, though, surviving spouses typically confront financial issues, which often trigger tax-related questions and consequences. Some of them are fairly straightforward, while others can be tricky.

That’s why Letha McDowell, president of the National Academy of Elder Law Attorneys, advises surviving spouses not to make major financial changes immediately. Instead, she tells them to reassess their finances from a tax perspective.

The loss of income after a spouse dies certainly has tax implications. For instance, if a drop in income means the surviving spouse needs to tap into a retirement account, McDowell points out that “the taxes may be less than initially anticipated because, if you have lower income, you may be in a lower bracket.”

Less income could also mean that the surviving spouse now qualifies for certain tax deductions or credits that have income caps or phase-out rules. Local jurisdictions often have income-based property tax breaks that may suddenly be available, too.

Eventually, every surviving spouse has a new filing status. A joint federal tax return is allowed for the year the deceased spouse dies if the surviving spouse didn’t remarry. The qualifying widow(er) status may be an option for two more years if there’s a dependent child.

After that, a surviving spouse who doesn’t remarry must file as a single taxpayer, which usually means less favorable tax rates and a lower standard deduction.

IRA rules are complex

Inheriting a traditional IRA can also affect the surviving spouse’s taxes, but first, there’s a decision to make.

An inheriting spouse can be designated as the account owner, roll the funds into their own retirement account, or be treated as a beneficiary. That decision will affect required minimum distributions and ultimately the surviving spouse’s taxable income.

As either the designated owner of the original account or the owner of the account with rolled-over funds, the surviving spouse can take RMDs based on their own life expectancy.

If they choose the third option — staying as the IRA’s beneficiary — RMDs are based on the life expectancy of the deceased spouse.

“Almost everyone either rolls [an inherited IRA] into their own IRA or at least they transfer it into an account in their name,” McDowell noted. “Consolidating makes things much easier to manage.”

The third option may make sense if the surviving spouse is at least 72 years old, but the deceased spouse wasn’t. In that case, RMDs from the inherited IRA are delayed until the deceased spouse would have turned 72.

Basis of inherited property

A surviving spouse also receives a stepped-up basis in other inherited property. “If the assets are held jointly between spouses, then there’s a step up in one half of the basis,” McDowell said. “But if an asset was owned solely by the decedent, then that would be a step up of 100%.”

In community property states, the total fair market value of property, including the portion belonging to the surviving spouse, becomes the basis for the entire property if at least half its value is included in the deceased spouse’s gross estate.

There’s also a special rule that helps surviving spouses who want to sell their home.

In general, up to $250,000 of gain from the sale of a principal residence is tax-free if certain conditions are met. The exemption jumps to $500,000 for married couples filing a joint return, but a surviving spouse who hasn’t remarried can still claim the $500,000 exemption if the home is sold within two years of the deceased spouse’s death.

As for estate taxes, there’s an unlimited marital deduction as well as this year’s $11.7 million estate tax exemption (the amount is adjusted annually for inflation).

If the deceased spouse’s estate is nowhere near that amount, the surviving spouse should still file Form 706 to elect “portability” of the deceased spouse’s unused exemption amount. This protects the surviving spouse if the exemption is lowered, as President Joe Biden and others have proposed doing.

If that happens, “it’s going to be important for a surviving spouse to have elected portability,” McDowell warned. “And if you don’t file, you don’t get it.”