Tax on Capital Gains While Receiving Social Security Benefits

I wrote about tax-free capital gains when you are in the 15% tax bracket or lower. I created this chart to make it clearer what I’m talking about (click on the chart for a larger size).

Your gross income first goes toward the pre-tax deductions from your paychecks (401k, health care insurance premiums, flexible spending accounts). Then it fills the deductions (at least $6,100 single, $12,200 married filing jointly in 2013) and exemptions ($3,900 per person including dependents in 2013). Only the income above the gray line is taxable.

If after subtracting all those, your taxable income doesn’t quite reach the top of 15% bracket (red line in the chart, $36,250 single, $72,500 married filing jointly in 2013), the green block under the red line is your opportunity to realize long term capital gains for free.

It gets more complicated if you are receiving Social Security benefits.

If you don’t have much income outside Social Security, your Social Security benefits are tax free, and you likely won’t pay any tax. As you create more income (for instance by realizing capital gains), a part of your Social Security benefits will be taxed, but at a low rate. As a result, your overall tax rate is still very low. If you realize more gains, more of your Social Security tax will be taxed and at a higher rate. After you pass a hump, the tax rate on additional income drops back down.

Example 1: Jane and David, both 66, married filing jointly, receive $30,000 a year in Social Security benefits. They don’t have any other income or deductions besides their personal exemptions and the standard deduction. If they realize long term capital gains, how will the gains be taxed?

It depends on how much in long term capital gains they will realize. Using the online tax calculator TaxCaster, by increasing the long term capital gains (LTCG) by $1,000 at a time, I get the following results:

Realized LTCG Tax Marginal Rate Blended Rate
$47,000 $0 0% 0%
$52,000 $423 8.5% 0.8%
$64,000 $423 0% 0.7%

The first $47,000 in long term capital gains is tax free. The next $5,000 is taxed at 8.5%. The next $12,000 is tax free again.

Altogether, this couple can realize $64,000 in long term capital gains on top of their $30,000 in Social Security benefits and pay only 0.7% in federal income tax on the capital gains. Isn’t that a great deal or what?

The picture changes a little bit when you add other income, for instance retirement account withdrawals.

Example 2: Jackie and Adam, both 71, married filing jointly, receive $30,000 a year in Social Security benefits and $15,000 a year in Required Minimum Distributions (RMD) from their retirement accounts. They don’t have any other deductions besides their personal exemptions and the standard deduction. If they realize long term capital gains, how will the gains be taxed?

By playing with TaxCaster again, I get these:

Realized LTCG Tax Marginal Rate Blended Rate
$14,000 $0 0% 0%
$34,000 $1,673 8.5% 4.9%
$37,000 $2,034 12% 5.5%
$49,000 $2,034 0% 4.2%

The first $14,000 in long term capital gains is tax free. The next $20,000 is taxed at 8.5%. The next $3,000 is taxed at 12%. The next $12,000 is tax free again.

Altogether, their RMD will make it more costly for this couple to realize long term capital gains, but they can still realize $49,000 in long term capital gains on top of their $45,000 income from Social Security and retirement accounts, and they will only pay 4.2% in federal income tax on their $49,000 capital gains. 4.2% is not zero, but it’s still very low.

It’s still a great deal if you ask me. If you calculate the effective tax rate on their entire $94,000 income, it’s only 2.2%. A working couple earning $94,000 in wages will pay many times more than that.

The picture changes again when you have higher Social Security benefits and higher income from pension or retirement account withdrawals.

Example 3: Joan and Ben, both 72, married filing jointly, receive $40,000 a year in Social Security benefits and $25,000 a year in Required Minimum Distributions (RMD) from their retirement accounts. They don’t have any other deductions besides their personal exemptions and the standard deduction. If they realize long term capital gains, how will the gains be taxed?

By playing with TaxCaster again, I get these:

Realized LTCG Tax Marginal Rate Blended Rate
$0 $1,058    
$7,000 $1,653 8.5% 8.5%
$31,000 $4,689 13% 12%

The first $7,000 in long term capital gains is taxed at 8.5%. The next $24,000 is taxed at 13%. Gains over $31,000 will be taxed at the normal 15% rate.

This couple still gets a break on the first $31,000 in long term capital gains but the deal isn’t nearly as good as in Example 1 and Example 2. Although a blended rate of 8.5% or 12% is still better than the normal 15% rate, it may not make sense to pay tax and reset the basis higher now if they intend to hold the assets for a long time or leave the assets to their heirs for the step-up basis.

You will only know which scenario you fall into by playing with your own numbers in a tax calculator or tax software.

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Comments

  1. Nelz says

    I receive a total of $2535 per month from social security and DIC (VA benefit do to death of my spouse). I pay no income tax on either. I would like to start drawing from my IRA and Deferred annuity of which I have approx $500K. between the two.

    How do I know how much to draw and what tax bracket I will be in?

  2. Klaas says

    This doesn’t make sense to me. When additional income starts making Social Security income taxable, it’s at 50% for a while, then 85%. If the other income is capital gains taxed at 0%, then that would make your marginal tax rate 5%, then 8.5%, then 13%, but the 13% (85% of 15%) rate would apply until you hit the 25% bracket, at which point you’d also hit the 15% capital gains bracket and your marginal rate should be 36.25%. I don’t think there’s any provision that causes the taxable amount of Social Security to stop increasing once it starts.

    So I think you’ve found a bug in the TaxCaster. The other possibility, of course, is that I’m forgetting about some provision or interaction that makes what you wrote make sense. Can you (or anyone reading) point one out?

    • Harry says

      The taxable amount of Social Security stops increasing when it hits 85% of the Social Security benefits. If there is still room in the 15% tax bracket, additional long-term capital gains are taxed at 0%.

    • Klaas says

      Yup, there it is. Thanks!
      Now I need to go back to my SSB spreadsheet and see whether it has a bug or if I just hadn’t seen cases like that because I was running it with ordinary income and higher amounts of Social Security.

  3. Karen says

    My mother, on social security, sold her condo this year due to bad health. She is now living with my husband and I. She made $116,000 after fees. Will she need to pay tax on the money from the sale? Does she have a time limit to reinvest the capital? We are looking at purchasing a larger home which she is going to invest all or part of the money from her condo sale.

  4. ron says

    My spouse and I make combined 78,000.00 in pensions and had 47,000.00 in long term capital gain. Paid my LTCG tax already at 15%. Am I to understand that I add 85% of my social security onto the 78,000.00 or add it to the 78,000.00 +47,000.00 to get my taxable income? That would take my whole tax rate up to 25% after already paying the capital gains tax.

    Where do itemized deductions come into play? Or don’t they.

    If I wasn’t taking SS, I could itemize my deductions and take that 78,000.00 down to 48,000.00. With SS, I have to add my SS benefit onto my 78,000.00 or 78,000.00+47,000 to figure my taxes? And, not be able to use my deductions?

    I would be paying 35,000.00 in fed tax, + the capital gains tax I already paid. Why the heck would I want to take my SS in the first place? Please help me figure this out.

    • Harry says

      You add “up to” 85%, not exactly 85%, of your SS to your $78k. You still take the same itemized deductions. If you have enough income already, you can suspend your SS to age 70 for a higher benefit at that time.

  5. M.S. Francis says

    We receive less than $30,000 a year in SS payments. We are both 67 and have no other income. My husband and his family have 2 houses remaining in family corporation. Have put one house up for sale for $200,000. His portion will be 17% of sale price. Will we have to pay Capital Gains tax? I

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