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Nothing says 'Ilove you' like a big tax bill
January 21, 2013
by Brian Wolf

Without the proper tax planning, many people could end up with a much higher tax bill then they had expected.

For example, John and Jane Doe had the following challenge: while they were both alive, their annual income tax liability was pretty low, less than $1,500, but upon either one of them dying, the annual income tax liability for the surviving spouse was projected to skyrocket to over $7,500, which is more than a $6,000 increase.

Needless to say, this would be quite a shock for the living spouse.

It is because a decent portion of their income comes from their IRAs. While they are both alive, they file tax returns as “married, filing jointly.” These tax brackets are some of the most lenient in the entire tax code.

But, when one of them dies, the surviving spouse files taxes as a “single” taxpayer, and these are some of the harshest brackets in the tax code.

Like a lot of people, John and Jane Doe had a large percentage of their assets in retirement plans. IRAs and other retirement plans, inlcuding 401ks, 403bs can cause significant tax challenges for surviving spouses, as we see in our little example.

Now, what might surprise you is that the story above is not uncommon. In fact, it is actually a very common issue, and it may very well apply to you.

So what should you do about it?

To start with, I would advise that you talk with a very knowledgeable tax and financial planning advisor so you can get the proper advice.

Then, you need to find out what your tax return would look like for your surviving spouse (or you, if you are the survivor). This analysis will tell if you have a potential problem.

If you do, then here is just one really simple idea that you may want to consider.

Why not distribute some extra income out of your IRA (or other retirement plan) today, and each year thereafter, while you and your spouse are both alive and enjoying those lenient tax brackets?

Yes, you will owe additional tax on those distributions, but here is the important part – that additional tax does not affect your current lifestyle.

Then, what if you took that after-tax amount of the distribution each year and used it to fund a life insurance policy on both your life and the life of your spouse?

I bet you weren’t expecting that one.

Life insurance; what if you’re older? Wouldn’t that be expensive?

Surprisingly, due to increasing life expectancies, life insurance pricing has dropped considerably. As a result, planning like this becomes very effective.

The nice thing is that when the first spouse passes away, the surviving spouse receives a nice big tax-free check from the life insurance company.

They can use that check to do a number of things.

• They might convert the IRAs to Roth, and pay the tax from the life insurance proceeds. Then all income from the IRAs would be 100 percent tax-free.

• They might pull some additional income from the life insurance proceeds, again positively managing their tax return.

• If the life insurance policy is large enough, they might go ahead and give the tax toxic IRA money to the kids, and live off of the life insurance proceeds.

As you can see, adding a large tax-free check to the list of assets that a surviving spouse has to work with can make a huge difference for them. And remember, for the surviving spouse, any additional income tax does affect their lifestyle.

So, why not consider paying some extra tax today when it does not affect you, so that your surviving spouse (or you) can avoid taxes later when they do affect you?


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