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Joe Elsasser, CFP, president and CEO of Covisum

Financial Planning > Tax Planning > Tax Deductions

How to Help Retirees Avoid Tax Traps in Social Security, Capital Gains

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What You Need to Know

  • The sources from which a retiree withdraws income can affect how much of their Social Security is taxed.
  • Ordinary income can increase a retiree's capital gains tax rate.
  • Capital gains tax brackets also come into play with planning strategies like Roth conversions.

An Orion study recently found 80% of investors believe their advisors should focus on minimizing their tax obligations, especially for clients in retirement, said Joe Elsasser, Covisum founder and president, during a recent webinar that focused on retirement tax strategies for RIAs.

With that in mind, he began by reviewing Social Security taxation, which he said should be a first step for advisors. He also discussed capital gains taxes and Roth conversions, among other areas where taxes can get tricky.

Provisional Income

Provisional income is a measure used by the IRS to determine when Social Security benefits are subject to income tax. It is calculated using:

  • Half of Social Security benefits.
  • Ordinary income, including any IRA withdrawals or wages
  • Dividends and capital gains
  • Nontaxable Interest

For a married couple, Social Security benefits are not taxed until provisional income reaches $32,000. On provisional income between $32,000 and $44,000, half of Social Security benefits are taxed. Above $44,000, 85% of benefits are taxed.

For individuals, half of Social Security benefits are taxed when provisional income is between $25,000 and $34,000. Above that threshold, 85% of benefits are taxed.

The sources from which provisional income is drawn can make a huge difference on taxation, Elsasser pointed out. For example:

1) In a year, a couple receives $40,000 in Social Security benefits and takes a $20,000 IRA withdrawal. That is $40,000 of provisional income ($20,000 in Social Security and $20,000 from the IRA). The $40,000 minus that $32,000 threshold equals $8,000, of which 50% is taxed. The couple will pay income tax on $4,000, or on 10% of their income.

2) In a year, another couple receives $20,000 from Social Security and withdraws $40,000 from their IRA. This is $50,000 of provisional income ($10,000 from Social Security and $40,000 from the IRA), which when subtracted from $32,000 comes to $18,000, of which $9,000 is taxed. Meanwhile, $6,000 of their income will be above the $44,000 threshold. An additional 35% of that income, or $2,100, will be taxed. This means the total taxable benefit is $11,100 ($9,000 plus $2,100), or on 22% of their income.

Further, when the standard deduction is taken into account, the second couple reaches a net taxable income of $22,400. Couple number one comes up with taxable income of zero. Since their taxable income is below the standard deduction, the first couple could even take out a little more from their IRA and still pay no income tax, Elsasser pointed out.

Capital Gains Tax

Elsasser also emphasized that ordinary income can increase a retiree’s capital gains tax rate. In 2021, the 0% bracket for the capital gains tax was $83,350. Add the standard deduction, and a couple could earn up to $112,050, in capital gains and ordinary income combined, before being liable for any capital gains tax.

But, Elsasser said, let’s say a client had $100,000 in capital gains with $28,000 of ordinary income. The ordinary income is “stacked” under the capital gains, pushing the gains above the $112,050 threshold into the 15% tax bracket.

“There is an interaction we really want to pay attention to because it matters a lot when we’re working with clients on these tax plan strategies,” he said.

Medicare Premium Surcharges

Couples with up to $182,000 of income pay a Medicare Part B premium of $170.10 a month in 2022. Clients with even a dollar of income above that level must pay an income-related monthly adjustment amount, commonly known as an IRMAA surcharge.

For example, if the couple makes $182,001 in income, their Part B monthly payment jumps to $238.10, and their Part D monthly cost is plan plus $12.40. IRMAA surcharges increase further as income rises.

3.8% Net Investment Income Tax

This is an additional 3.8% tax on net investment income (applying only to capital gains, interest and annuity payments, passive business income and rents) of those with adjusted gross income of $200,000 or more for single filers and $250,000 for couples.

Spotting Tax Opportunities

A key way advisors can spot tax opportunities for clients is when the effective marginal rate on the next dollar is significantly different than the average lifetime EMR, Elsasser said.

Roth Conversions

Elsasser discussed different types of IRA opportunities, including Roth conversions (which were a fan favorite in an early poll by Elsasser). One factor to keep in mind: Although Roth conversions are generally a smart strategy, amounts should be limited to avoid pushing capital gains into a higher tax bracket.

But advisors should begin with Social Security strategies because they “add significant value” to clients’ lives, especially when they allow clients to delay claiming, Elsasser said.

Also important is the gap between when a client stops working and when they collect Social Security. This is a good time to use Roth conversions, Elsasser noted.

But he noted that there are times when delayed Social Security claiming is not the best long-term strategy, a point he illustrated using his software. For example, clients who withdraw from an IRA while delaying benefits might reduce the future value of their estate by more than they collect in extra Social Security payments during their lifetime.

Net Unrealized Appreciation (NUA)

This allows for a client who has appreciated company stock in their 401(k) to transfer that company stock in-kind to a brokerage account, which allows them to pay ordinary income tax on only the basis.

For example, Elsasser said, a client paid $100,000 for stock that is now worth $500,000. If they sell the stock and withdraw the money from the 401(k), all $500,000 of it will be taxed as income.

But if they transfer the stock to a brokerage account, only the $100,000 basis will be taxed as ordinary income, while $400,000 will be taxed as an embedded capital gain.

In most cases the capital gain rate will be lower than the ordinary income rate, Elsasser noted, adding that clients might want to stretch out the NUA over a couple of years to stay under the capital gains threshold.

How to Reduce Capital Gains Taxes

There are three key ways to reduce capital gains taxes, he noted:

  • Reduce ordinary income: A simple way to do this is make an IRA contribution.
  • Harvest capital losses: Keep in mind that clients should harvest only those losses that fall into the 15% capital gains bracket. “Blindly harvesting capital gains losses can be a real waste,” he noted.
  • Harvest capital gains: This allows a client to sell some of their portfolio, realize the gains, then buy it back so there is a step up in basis. This may allow the client to take advantage of the 0% capital gains tax bracket.


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