To Roth or not to Roth?
That is the question to which I devoted not one, but two, separate Retirement Weekly columns earlier this summer. I based the first of them on research from Edward McQuarrie, a professor at Santa Clara University’s Leavey School of Business, who found that, in most cases, converting your IRA or 401(k) to a Roth makes surprisingly little difference to your retirement standard of living. I focused the second column on a number of your questions and objections.
There’s one objection which remains, and potentially it’s a big one. So I’m devoting an entire column to addressing it. The objection traces to what’s known as the “Widow Tax Hit,” because of which you should undertake a Roth conversion.
The Widow Tax Hit refers to the higher tax rate that a widow may have to pay after her husband passes. This is more properly referred to as the “Surviving Spouse Tax Hit,” of course. But in this column I will refer to it by its conventional name, since manipulative financial planners often target vulnerable husbands who feel guilty at even the suggestion they may have not adequately provided for their wives.
The simplest statement of the Widow Tax Hit is that, other things being equal, she will immediately jump into a higher tax bracket upon the death of her husband. That’s because a single taxpayer is subject to a higher tax rate than a married couple filing jointly on the same amount of income.
Much rests on the phrase “other things being equal,” however, since in the real world rarely do things stay the same. After constructing a model to incorporate the several ways in which things can and will change after the death of a spouse, McQuarrie found that a Roth conversion is not needed to insure that widows will have similar levels of after-tax income as they had before the death of their spouse.
The reason McQuarrie needed to construct his model to analyze the Widow Tax Hit is that intuition is a poor guide to what a widow’s after-tax income will be after her spouse passes. For example, McQuarrie points out, the amount the widow will pay in taxes doesn’t automatically double after the death of her husband, even if her income doesn’t change. When her tax rate doubles, her total tax bill does not, since her tax rate applies at the margin—to the amount by which her income exceeds the threshold for her marginal rate. That nuance is all too often glossed over by misleading financial planners who use fearmongering tactics to sell Roth conversion strategies, McQuarrie said in an interview.
Another nuance is that a widow’s expenditures are likely to fall, relative to what she and her husband had previously spent. Even when a widow’s tax bill increases, the reduction in her expenditures in many cases can offset much or all of that increase. Her after-tax disposable income, net of fixed expenses, would therefore be substantially the same as her share had been before the death of her spouse. A full discussion of these and other myriad details is beyond the scope of this column. Interested readers are directed to read McQuarrie’s study “The Widow Tax Hit: Much Ado About Nothing?”
Note carefully that McQuarrie doesn’t deny that, in some instances, a widow’s after-tax disposable income will indeed drop significantly. But, he found, the culprit in those instances isn’t an increased tax rate but a drop in income. In fact, he told me, upon exploring any of a number of different possible scenarios, he “couldn’t find a single instance that could not be traced back to income loss rather than increased taxes.”
Income loss after the death of a spouse is something that retirees and financial planners should worry about, of course. But the proper way to address it would be to evaluate other income replacement strategies in addition to a Roth conversion—such as life insurance.
The general lesson here is the importance of running the numbers when contemplating major decisions impacting your retirement standard of living. A Roth conversion might make sense for you, or it might not. But you won’t know without analyzing a number of interacting factors.
This general lesson is especially important when focusing on emotionally-charged subjects like running out of money in retirement or the guilt each half of a couple might feel at the prospect of not adequately providing for their spouse’s financial security after the first of their deaths.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].
