Do Capital Gains Affect Social Security Taxation?

Many retirees find that the Social Security benefits they depend on can be subject to federal income tax. A portion of your benefits may be taxable, depending on your total income from all sources. This raises a financial planning question for retirees with investments: can realizing capital gains from selling assets like stocks or real estate trigger or increase the tax on Social Security benefits?

The Provisional Income Formula for Taxing Social Security

The Internal Revenue Service (IRS) determines the taxability of Social Security benefits using a calculation for “provisional income,” also called combined income. This figure is calculated for this purpose. The formula has three components: your Adjusted Gross Income (AGI), any nontaxable interest, and 50% of the total Social Security benefits you received for the year.

Your AGI includes most taxable income sources, such as wages, pension payments, and distributions from traditional retirement accounts. To this, you add interest that is exempt from federal tax, such as interest from municipal bonds. The final component is one-half of your annual Social Security benefits. Summing these three amounts gives you your provisional income.

Once calculated, your provisional income is compared against IRS thresholds that vary by filing status. For individuals filing as single, provisional income of $25,000 or less means benefits are not taxed. Between $25,001 and $34,000, up to 50% of your benefits may be taxable. Over $34,000, up to 85% of your benefits could be subject to income tax.

For those married and filing a joint tax return, if your combined provisional income is $32,000 or less, none of your benefits are taxed. If it is between $32,001 and $44,000, up to 50% may be taxable. For joint filers with provisional income exceeding $44,000, the taxable portion can be as high as 85%. These thresholds are not indexed for inflation, meaning more retirees find their benefits being taxed over time.

How Capital Gains Influence Provisional Income

Capital gains directly influence whether your Social Security benefits are taxed because they are a component of your Adjusted Gross Income (AGI). When you sell an asset—such as stocks, bonds, or real estate—for more than your purchase price, the resulting profit is a capital gain. This gain is added to your other income sources and contributes directly to your AGI for the year.

Since AGI is a primary part of the provisional income formula, a capital gain increases your AGI, which in turn inflates your provisional income. This increase can push you over the IRS thresholds, causing a portion of your Social Security benefits that might have been tax-free to become taxable. This applies to both short-term and long-term capital gains. Even though long-term gains are taxed at preferential rates, they are still fully included in the AGI calculation for determining your provisional income.

A Step-by-Step Calculation Example

To understand the impact of capital gains, consider a married couple filing jointly. They have $30,000 in annual Social Security benefits, $35,000 in withdrawals from a traditional IRA, and no nontaxable interest.

Provisional Income WITHOUT Capital Gains

Their Adjusted Gross Income (AGI) consists of their $35,000 IRA withdrawal. The provisional income calculation is: $35,000 (AGI) + $0 (nontaxable interest) + $15,000 (50% of $30,000 Social Security) = $50,000.

Introduce a Capital Gain

Now, the couple sells a stock, realizing a profit of $15,000. This capital gain is added to their other income, changing their AGI for the tax year.

Recalculate Provisional Income WITH Capital Gains

With the capital gain, their new AGI becomes $35,000 (IRA withdrawal) + $15,000 (capital gain) = $50,000. Their new provisional income is: $50,000 (new AGI) + $0 (nontaxable interest) + $15,000 (50% of Social Security) = $65,000.

Show the Impact

Initially, their provisional income was $50,000. For a married couple filing jointly, this is over the $44,000 threshold, meaning up to 85% of their benefits would be taxable. After the $15,000 capital gain, their provisional income jumped to $65,000. This increase keeps them in the 85% taxable tier and results in a higher overall tax bill, as the capital gain amplified the taxation of their Social Security benefits.

Strategies to Minimize the Tax Impact

Several strategies can help lower your AGI or manage the timing of income to control the tax on your Social Security benefits.

• Tax-loss harvesting involves selling investments at a loss to offset any capital gains realized during the year. The losses cancel out the gains, which directly reduces your AGI and, consequently, your provisional income.
• Timing your asset sales can be effective if you anticipate a large capital gain. You might consider spreading the gain over multiple tax years through an installment sale, where payments are received over time. This may keep your provisional income below the higher taxation thresholds.
• Using Roth retirement accounts offers a way to manage your retirement income. Qualified distributions from a Roth IRA or Roth 401(k) are tax-free and are not included in the provisional income calculation.
• Making a Qualified Charitable Distribution (QCD) is an option for individuals over age 70.5. A QCD allows you to donate up to $105,000 (for 2024) directly from a traditional IRA to a qualified charity. This amount can count toward your Required Minimum Distribution (RMD) but is excluded from your AGI.