CAPITAL GAINS AND the tax cuts job act
Before you see how long-term capital gains can potentially be double taxed in retirement, you must first understand how these gains are taxed. Prior to the Tax Cuts and Jobs Act (TCJA) passed at the end of 2017 and applicable for 2018 the capital gain rate was based on your ordinary income bracket. If your ordinary income bracket, for a couple filing jointly, fell within the 10% to 15% bracket your capital gain tax rate was 0%. If your ordinary income bracket was in the top 39.6% bracket your capital gain rate was 20%; for everyone in the middle (brackets from25% through 35%) the capital gain tax rate was 15%.
TCJA changed all that. If you understood long-term capital gains taxes prior to this year you will have to relearn how these taxes are calculated. Capital gains taxes are no longer tied to your ordinary income tax bracket but, instead, now have their own individual brackets. For joint filers with capital gains and qualified dividends below $77,200 the capital gain tax rate is 0%. For gains between $77,201 and $479,000 the rate is 15% and for long term capital gains over $479,000 the rate is 20%. Short-term capital gains are included in ordinary income.
UNDERSTANDING SOCIAL SECURITY TAXES IN RETIREMENT
Okay, keeping the above in mind, how can capital gains be double taxed? Before we get to that point, we should understand how things change once you are retired and receiving Social Security. The amount of your Social Security that is taxed is based on the amount of your provisional income which equals one-half of your Social Security plus your Adjusted Gross Income plus Tax Exempt Interest. Long-term capital gains are included in Adjusted Gross Income regardless of whether the gains are taxable. It is critical to understand this point because, while your capital gains may not be taxable, these gains can cause more of your Social Security to be taxed.
Let’s look at an example to illustrate this point. John and Mary are 66 years old and have joint Social Security benefits of $57,600 and are taking IRA distributions of $17,400. Because only $7,870 of their Social Security is taxed, and their standard deduction is $25,300, they owe no federal taxes. They have a stock with a $25,000 unrealized gain that they would like to sell. They look up the 2018 long-term capital gain rates and see that this puts them in the 0% tax bracket. They sell the stock.
John is having lunch when his CPA and brags about being able to sell the stock and not pay any taxes. His CPA says, “Wait a minute, I think you are incorrect.” He gets out his calculator and tells John that he will actually owe $2,165 in taxes (this equals 8.66% of the gain of $25,000). The tax is not a capital gain tax, it is tax on ordinary income. What happened is the capital gain, when added to Adjusted Gross Income, increased their taxable Social Security from $7,870 to $29,120 resulting in their taxable income, which was zero, now being $46,220.
HOW CAPITAL GAINS ARE DOUBLE TAXED
So how are long-term capital gains double taxed? Using the example above, but changing the long-term gain to $100,000, what happens when we put these numbers in our tax calculator at the bottom of this page? Because $22,800 of the $100,000 is in the 15% long-term capital gain bracket we would assume we would pay $3,420 in capital gain taxes (15% times $22,800). This is a correct assumption. However, because their taxable Social Security is now $48,960 the total tax bill is now $14,125. We expected an effective tax rate on the gain of 3.42% ($3,240 divided by $100,000). Because of the increase in ordinary income taxes, the real effective rate on the gain is 14.13% ($14,124 divided by $100,000).
Hopefully you were able to follow the math through these examples. TCJA was touted as tax simplification; for retirees this certainly isn’t the case. There are numerous variables in taxation that can cause surprises. The only way to really get a handle on your tax situation is to include all expected sources of income into a long-term tax projection. Using our tax calculator at the bottom of the page is a good place to start but it does not project future tax liability. TCJA is due to sunset in five years so it is critical you examine your long-range tax liability assuming TCJA is allowed to sunset and also that it is made permanent. I would be happy to prepare a tax projection for you so that you don’t receive any ugly surprises as you enter retirement.