Tax on Capital Gains While Receiving Social Security Benefits
I wrote last week about tax-free capital gains when you are in the 15% tax bracket or lower. I created this chart over the weekend 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 $5,800 single, $11,600 married filing jointly in 2011) and exemptions ($3,700 per person including dependents in 2011). 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, $34,500 single, $69,000 married filing jointly in 2011), 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, if they intend to hold the assets for a long time or leave the assets to their heirs for the step-up basis, it may not make sense to pay tax and reset the basis higher now. See previous post Taxes Going Up, Reset Cost 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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Software picked, likely related posts:
- Reset Cost Basis Higher By Realizing Capital Gains
- Social Security Benefits Increase More Rapidly For Retirees Than For Those Still Working
- Payroll Tax Cut and Social Security Benefits
Comments
2 Comments on Tax on Capital Gains While Receiving Social Security Benefits
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Nelz on October 19, 2012
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?
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Harry on October 23, 2012
Nelz – You can use the same tax calculator I used in this post. Try different numbers and see how your taxes change. It’s called TaxCaster.
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