By: Joseph Goldy, CFP®
For many newly independent women, taxes are not necessarily at the top of their priority list when we start discussing their financial situation. Whether it is the loss of a spouse or just having gone through a divorce, making sure they and their children will be ok is the primary goal.
However, through our planning process, we identify potential tax pitfalls or opportunities early on since life-changing events can significantly impact someone's tax situation. This article will focus on three common areas: filing status, retirement accounts, and home sales.
3 Common Tax Pitfalls
1. Filing Status
For someone who is widowed, you are allowed to use the married filing jointly status in the year of a spouse's passing. Beyond that initial year, if you have a dependent child, you can use qualifying widower status (which has the same brackets as married filing jointly) for the next two years.
The qualifying widower filing status is beneficial since it offers more favorable tax brackets than filing as a single person. For example, someone with a taxable income of $100,000 filing jointly would be in the 22% bracket. That same person filing as a single person would be in the 24% bracket meaning $2,000 more in potential tax liability.
By the third year following a spouse's passing, you would have to file as a single person unless you remarried.
For newly divorced people, you may have a choice whether to file as a single person or head of household. Although not quite as favorable as married filing jointly, the head of household bracket is more advantageous than filing as a single person.
To qualify for head of household, as of December 31st of the filing year, you must be unmarried. Other requirements include you must pay for more than half of household expenses, and you need to have a qualifying child or dependent. Always check with a CPA or your financial advisor to ensure you qualify, as there are additional requirement details beyond the scope of this article.
2. Retirement Accounts
Inheriting a retirement account from a spouse that has passed away presents options for the surviving spouse.
Treat as Own: The surviving spouse can choose to move a deceased spouse's IRA assets into their own IRA (known as "treat as own"). The benefit of the treat as own option is that the deceased spouse's assets go directly into the surviving spouse's own IRA, helping consolidate accounts and creating simplicity for Required Minimum Distribution purposes in the future.
A potential downside to this option is that if any funds are needed before reaching 59 ½ years old, the surviving spouse would be subject to standard IRA withdrawal rules meaning possible taxes and penalties will apply. Despite these rules, treating as your own is often a common choice when a spouse inherits an IRA.
Move Assets into a Inherited IRA: A second option is to move the deceased spouse's assets into an Inherited IRA. The benefit of moving the assets into an inherited IRA is that if the funds are needed, they can be removed without the 10% penalty, although still subject to taxes.
Age is a factor here since RMDs are based on the latter of the year after death or when the decedent would have reached age 72. For younger surviving spouses, moving the assets into their own IRA rather than an Inherited IRA would make more sense (assuming they will not need to draw on the funds) since they are further from age 72 than their deceased spouse. The longer the assets continue to grow tax-deferred, the better.
Splitting an IRA: A separate IRA issue applies to newly divorced people. Suppose an IRA is subject to a court order or separate maintenance decree dividing the IRA account in two. In that case, it is critical to know the rules to avoid unexpected tax liability. If an IRA is to be split, ideally, it should be a tax-free trustee-to-trustee direct transfer of assets which will avoid tax withholding and is not reportable.
In contrast, receiving funds from an ex-spouse via check is considered a 60-day rollover and subject to the 60-day timeframe to deposit those assets into an IRA. A rollover is also reportable, and if you fail to get the funds back into an IRA, you will be subject to ordinary taxes on the withdrawal amount. There is no reason to split an IRA in divorce this way, and you should make every effort to ensure divided IRA assets use a transfer rather than a rollover.
3. Home Sale
For married couples, the Section 121 exclusion allows up to $500,000 in capital gains from selling a home to be free of taxes. This exclusion applies if you have owned and used the house as your primary residence for at least 2 of the last five years (the two years do not need to be concurrent, just within the 5-year timeframe before the home's date of sale).
Single individuals receive up to $250,000; however, surviving spouses can still receive the $500,000 provided they sell the home within two years of the deceased spouse's death. They also need to have not remarried during that period.
Fortunately for divorcees, the exclusion can also be used assuming both spouses had met the 2-year ownership and use tests. The difference is that each person would claim the $250,000 exclusion on their tax returns. Interestingly, the IRS allows a partial exclusion even if the 2-year ownership has not been met. For example, if one spouse had only lived in the home for one year instead of two, $125,000 of capital gains would be excluded rather than the total $250,000 (one year meets 50% of the two-year requirement, so you received 50% of the exclusion).
Although taxes may not be top of mind for someone just experiencing the loss of a spouse or going through a divorce, our job as fiduciary wealth advisors is to ensure any financial blind spots are addressed. Filing status, retirement accounts, and the sale of a home are three such blind spots that we cover in our planning process for newly independent women.
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.