Welcome to how to retire on time, a show that answers your retirement questions. Say goodbye to that oversimplified advice you've heard hundreds of times. This show is all about getting into the nitty gritty. Now that said, remember this is just a show, not financial advice, so do your research. As always, you can text your questions to (913) 363-1234, and we'll feature them on the show. David, what do we got today?

Hey, Mike. I'm getting taxed when my retirement income should be tax free. Everything comes from Social Security and long term capital gains. How can this be?

It's a mystery.

We need Scooby and Shaggy to come solve it?

Yeah.

The mystery machine, man.

We can solve it though.

Alright.

So let's unpack it first. If he's talking about long term, or she, he's talking about long term capital gains

Yes.

Then the much of their retirement must be in a brokerage account.

so we're not dealing with RMDs here. We're not dealing with any of that. Okay? It looks like they would have been a buy and hold, like buy ETFs or stocks, hold them for a long term period of time, and then sell it within the long term capital gains bracket. Now long term capital gains bracket for married filing joint, it's around 96, 97,000.

I don't remember what 2026 numbers are gonna be, but that the gains would be up to let's say just easy math,

a 100,000. So they could have a 100 k in gains from their original, like, basis.

So let's say they sell $200,000 of stock in a year, and a 100,000 of it was in gains, technically, all of that would be tax free from the capital gain standpoint.

Okay.

So the question, how am I being taxed? Yeah. Great question. Let's assume that there's no state tax in here as well.

Okay.

Because sometimes people know to expect capital gains with the state the state tax, not a state tax. Yeah. State capital gains tax, whatever might be. So assuming that that's not what they're talking about as well, we're trying to unpack this a little bit. Then my guess, since this is a retirement show, is they're also taking Social Security and did not disclose that.

They didn't disclose what? That they're taking Social Security.

Oh, who do they need to disclose it to?

To us. Oh, okay. So we can we can have the conversation. Yes. Okay.

Okay. Okay. So here's my guess. You've got them, let's say married finally jointly, and they're taking 40,000 or so from Social Security. Divide that by two, cut it in half, that's 20,000.

They're basically getting Social Security tax free in that situation. You'd think so. Because the provisional tax usually what and we've defined it this way, and shame on us for oversimplifying any definition, but you've got half your Social Security plus your tax exempt dividends.

Okay.

Right? So think municipal bonds, and then your income from places like your IRA or w two income or whatever it might be. And that's kind of how you'd calculate Social Security or the provisional income tax formula. They're probably thinking, well, hey. Our Social Security is taxed, and our capital gains is tax free as well, so we should be good to go.

The problem is the misunderstanding of Social Security taxes

Oh, okay.

And how it works.

Yeah. Do we wanna run through that?

Yeah. This has been nicknamed the tax torpedo.

What a great name. Yeah. Look it up.

I don't know who coined it, but it's kind of fun. So the problem is you from a capital gains tax, you're probably getting 0% on the taxes, but the capital gains are going to be included in your provisional income calculation. That's going to push your Social Security into the 50% or 85% thresholds, brackets, formula, whatever you wanna call it. And the reality is the 0% of Social Security tax, the 50% or the 85%, they're not really tax brackets like you would think in the other tax code.

Okay.

They're not really a progressive or an all or none necessarily. The provisional income calculation is how you figure out how much of your Social Security is subject to tax.

Okay.

So it starts at zero, and then 50%, and then 85%. And the problem here is, let's say they didn't take any capital gains tax. It was just Social Security. They'd have a 0% tax. Oh.

But because it's not a bracket, it's a formula. Now when you account for the capital gains that you're realizing, that's included in the formula. And so as that's included in this formula, what it does is it pushes more Social Security dollars, even though it's only 20,000 that would be calculated or 40,000 for the overall bit, it pushes it into the 85% threshold. Keyword threshold.

Uh-huh.

Okay?

Okay.

So think about it this way. Most people never realize that this is even happening because they're taking IRA distributions.

Oh,

yeah. And so because their IRA distributions, the maximum that they could be taxed on Social Security, the 85%, it's just already baked in there. They don't really look at it, so you don't see this as much. But for someone that can do tax strategies, basically, what they're gonna do is they're gonna take your whole provisional income and then run a calculation. And if that amount is greater than the Social Security calculation by itself, you're gonna be taxed more.

But it maxes out at 85% of your Social Security.

What maxes out at 85%?

The amount that would be taxed.

Oh, okay. Oh, yes.

This is a very confusing thing, but it shocks people, and they say, like, I was so careful about my tax planning.

Yeah. But I'm gonna do a

little bit more. I'm gonna I wanna just lock in some of my gains on some of these positions. I'm gonna sell it, but I'm getting taxed. Why am I getting taxed? The reason is you're not being taxed on the capital gains.

Your Social Security tax is increasing up to a certain point. So there's a likely chance that you were in the 50% threshold. Uh-huh. But because provisional income is a formula that takes half of your Social Security, it takes your other income sources and capital gains, long term or short term, they're still gonna be counted as part of this calculation. That's gonna filter down to where then you have up to a certain threshold that would be subject to tax.

So basically, more money goes into the calculation, so then more money will be taxed under that sleeve.

So this little capital gain is pushing the Social Security money that gets taxed through the threshold

Yeah.

Beyond 50%.

The technical way that people explain it is that the capital gains have pulled more Social Security income into the 85% threshold instead of the 50% threshold.

Okay.

So pull or push, whatever way you wanna look at it.

Yeah. Yeah.

Yeah. And this is why it's so important to understand tax consequences. If you were, let's say, 65 years old or 63 years old, and let's say the Affordable Care Act still had subsidies Mhmm. You might not wanna take Social Security, let it grow, and be more tax efficient later on instead of this tax torpedo where you're triggering two taxes in some sense, and then you just delay your Social Security for a later point of time. That's not that bad of a deal.

Yeah. Maybe that the tax consequences aren't significant enough that you're okay with the tax torpedo and paying a little bit more in your Social Security taxes. It's just any time you make a move in finance, especially in retirement planning, it's likely going to affect many other parts of your plan, portfolio, and or tax return. There's a ripple effect.

Yeah. So the reason this person and tell me, correct me if I'm wrong. This person's feeling like their retirement income, more of it's getting taxed. It's it's basically because more of the Social Security income is getting taxed.

They probably have no idea. Yeah. Because tax calculators don't necessarily show you where it's coming from. There's here's the tax bill, and you have to reverse engineer what's going on.

Mhmm.

So the easy way I've figured this out is so that's line seven on your ten forty, if you really wanna play with it. If you have access to a tax calculator like this. Uh-huh. But you just see if you hey. If you're doing a simulation, you did not have long term capital gains, would your Social Security be tax free or would it not?

Then add it in, and then you're gonna see the consequences. So you may still be tax free from a capital gain standpoint, but you may pull more Social Security into a higher tax bracket. And are you okay with the unintended consequences? Uh-huh. That's kind of a way to look at it.

And I would say this, actively avoiding taxes really hurts you probably more than the government. No one wants to pay more in taxes, but the rules are set up as they are. You're not really gonna change the rules this year. And is avoiding taxes going to negatively affect your overall quality of life?

Yeah. Everybody's gotta answer that for themselves. So let's say that this person and I don't wanna go too long on this, but let's say they don't have any brokerage accounts, so there's no capital gains. They're taking all of an IRA. Does this question, like, become totally moot to them?

Like

You're taking it from a distribution, so it's still gonna affect your provisional income, but you're more likely to hit the 85% threshold, and then it's the same thing anyway for Social Security taxation.

Oh, okay. Well, yeah. I think that makes sense. So be careful of bursting through thresholds like the Kool Aid man, through a wall.

Yeah. Social Security tax is much more complicated than people realize. It's a very important part of retirement planning. I mean, unless you just like to throw away a thousand to $2,000 every year away just because you don't wanna look. It's often not talked about.

It's often not mentioned in these Social Security analyses that people get, because those are just focused on if I file here versus I file there. Well, what's what's the difference? Well, there's other factors at play here. It's much more complicated conversation when you wanna look at timing when to file for your benefits. The tax torpedo, look it up.

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