3 stealth taxes that can kill your capital gains
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 quagmire of complex rules, and very often the actual amount of tax you pay is deceptively higher. Here are three indirect ways that your profit on capital gains can drain your wallet today and even in the future.
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 including 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 when they filed their tax return that 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 to the 15% tax bracket, and the bite is even worse. A conversion where you expect to pay 15% can actually end up costing almost 26%.
Increased Medicare premiums
As I described in my column "Why You Should Save Roth IRA and HSA Distributions for 2016," 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 table below illustrates this concept:
The "gotcha" moment occurs when your realized capital gains 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%.
Additional alternative minimum tax
One of the worst culprits is the alternative minimum tax (AMT). Most people don't think that capital gains activate additional AMT since the stated capital gain tax rates are the same for both regular and AMT purposes (15% or 20%).
Unfortunately, the AMT calculation is its own convoluted beast: Realizing capital gains can cause your other types of income (IRA distributions, Social Security, pension, etc.) to be subject to an AMT tax rate as high as 35%. That's no typo, even though the stated AMT rate for these types of income is 26% or 28%, the actual rate paid can be as high as 35% (a dirty little secret, isn't it?).
For example, take Jeff and Emily, a married filing jointly couple with $50,000 in Social Security benefits, $120,000 in IRA distributions and $50,000 in interest/dividend income. They decide to realize $10,000 of long-term capital gains. The stated rate on capital gains for the regular and AMT calculations is 15%, but is that their actual tax rate? Nope — the gains increased Jeff and Emily's AGI by $10,000, and separately made an additional $3,500 of their other income subject to the AMT at 35%. The net effect of this gobbledygook is that $10,000 of gains increases the total tax liability by $2,150 (a 21.5% tax rate).
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 have 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.