As the end of the year approaches and tax planning becomes a priority (you’re missing out if it isn’t), one common strategy is to realize capital losses to offset realized gains for the year. But for many retirees, one particularly juicy strategy is to do the opposite: realize capital gains to take advantage of their preferential tax rates.
The IRS states that long-term capital gains rates are generally 0%, 15%, and 20%. Unfortunately, this is only the sticker price for what you pay. The tax code is a quagmire of complex rules, and very often the actual amount of tax you pay is deceptively higher. Here are four sneaky taxes that can drain your profits on capital gains:
More Tax on Social Security
It’s a shock to many that Social Security benefits are taxable. The amount subject to tax is based on your “provisional income,” which is the sum of 50% of your Social Security benefits and your other income sources like IRA distributions, pensions, dividends, wages, capital gains and tax-exempt interest (yes, tax-exempt interest can create additional tax on your Social Security earnings). Depending on your situation, up to 85% of your Social Security benefit may be taxable.
Here’s an example: Larry and Sheila are married and file jointly and receive $40,000 of Social Security benefits and $20,000 of pension benefits. They need to purchase a new car and identify they are eligible for the 0% capital gains tax rate, so they decide to sell stock and realize a $25,000 capital gain. Although they expected no change in their tax liability, they were surprised to find out that when they filed their tax return, the liability increased by $2,225. While the $25,000 capital gain did qualify for the 0% tax rate, the amount of Social Security subject to tax increased from $4,000 to almost $24,000, indirectly causing an almost 10% effective tax rate on the capital gain.
Beware: This same “gotcha” can “getcha” when implementing Roth conversions to fill the 12% tax bracket, and the bite is even worse. A conversion where you expect to pay 12% could actually end up costing upwards of 27%.
Increased Medicare Premiums
The amount someone pays for Medicare isn’t dependent on their health status or wealth. Instead, it’s based on the income you realized two years prior to the year you pay your premiums.
The “gotcha” moment occurs when you realize capital gains that bump you up a premium bracket. For example, Sue is single and has $25,000 in Social Security benefits, $25,000 in pension benefits and $35,000 in IRA distributions. She decides to sell some stock, realizes a $10,000 capital gain, and expects to pay 15% on that gain ($1,500). Since this pushes her Adjusted Gross Income (AGI) just over the $85,000 threshold, Sue’s Medicare Parts B & D premiums will increase by $54.30 per month, or $651.60 per year (but not for another two years). She did pay 15% on the gain in the current year, but the eventual total tax impact of her $10,000 gain is $2,151.60—an effective tax rate of 21.5%.
So many people focus on the federal capital gains tax rates, but what’s often forgotten is your state tax liability—and depending on where you live, it can be almost as large as the federal tax rate. While most states don’t have a separate capital gains tax rate in the same way the federal government does, many will still tax capital gains just as they would regular income.
So, for people planning on a 0% tax rate on their capital gains, they may still have a state tax that is due, and for many states, that tax is in the 5–7% range. Those planning on the 15% federal capital gains rate could end up having up to 8–10% higher tax rates in higher tax states. And those in the highest tax states could get hit with an extra 12–13% tax on top of the 20% they owe from the federal capital gains tax rate.
Net Investment Income Tax
For individuals with an adjusted gross income (AGI) of more than $125,000 (or $250,000 if you’re married filing jointly), there’s an additional tax on capital gains called the net investment income tax (NIIT). This is a tax rate of an extra 3.8%, so depending on your income, it can bump your capital gains tax rate from 15% up to 18.8%, and if you have a 20% capital gains rate, the NIIT would bump it up to 23.8%. It might not seem like much, but that extra 3.8% may mean several thousand dollars of extra tax that you owe on your capital gain.
Understanding the true tax cost of selling stock is difficult to ascertain and paying the stated IRS tax rate can be difficult—if not impossible. That’s especially the case when you have little control over the amount of capital gains realized (mutual fund capital gain distributions). If you aren’t careful, these surprise taxes will chip away at your savings each and every year.
That’s why it’s critical to consult your financial advisor to gain a clear grasp on the impact of transactions before you execute them. Only then can you make informed, deliberate decisions to improve your life both today and tomorrow.
This material is for general information only and is not intended to provide specific advice or any recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Wealth Enhancement Group and LPL Financial do not provide tax advice.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of the conversion, withdrawal limitations for future contributions to a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
The examples provided in this article are hypothetical in nature and the results that you may experience will vary.
CFP®, CPA, Series 7 Securities Registration,1Series 66 Advisory Registration,† Insurance License Brian diligently advises clients on income, gift, trust and estate tax issues while leveraging the expertise of the Roundtable to deliver comprehensive, customized strategies. For more than 10 years he has helped numerous clients develop and implement sophisticated financial, tax and estate strategies that are in alignment with their goals and values. Brian is a...Read More