Archives for January 2019

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Tax-Loss Harvesting

One useful thing you can do with your portfolio during market declines is check your taxable accounts for opportunities to tax-loss harvest. (Note: tax-loss harvesting does not apply to IRAs or other tax-sheltered accounts.)

To explain what tax-loss harvesting is, let’s look at an example.

Mary is in the 24% tax bracket. At the beginning of the year, Mary bought $100,000 of Vanguard Total International Stock Index Fund in her taxable account. And let’s imagine that as of today, it’s worth approximately $93,000. To tax-loss harvest, Mary would sell that fund, thereby recognizing a $7,000 capital loss. And Mary would use the proceeds from the sale to purchase another fund to serve as a replacement in her portfolio.

Mary can use the $7,000 capital loss to offset any capital gains she realized this year. And if Mary’s capital losses exceed her capital gains for the year, she can use up to $3,000 of her net capital loss to offset ordinary income, thereby reducing her income tax by $720 (i.e., $3,000 x 24%). If she still has remaining capital losses after that, they can be carried forward to be used in future years (subject to the same limitation).

What’s the Point?

You may have noticed, however, that when you eventually sell the replacement fund, your capital gain will be larger than it would have been had you not tax-loss harvested (because the replacement fund will have been purchased at a lower price than the original fund).

To return to our example above, if Mary uses her $93,000 to purchase Vanguard FTSE All-World Ex-US Index, which she sells a few years later for $130,000, her long-term capital gain will be $37,000 rather than $30,000.

So did Mary still come out ahead? Yes, for a few reasons.

First, if nothing else, she deferred her taxes for a few years — in essence getting an interest-free loan from Uncle Sam.

Second, if she was able to use any of her $7,000 capital loss to offset ordinary income (or short-term capital gains), then the capital loss saved her money at a rate of 24% (because she’s in the 24% tax bracket). When she sells the replacement fund, the long-term capital gain will be taxed at a lower rate (likely 15%).

Finally, if Mary had ended up dying before she sold the fund, the savings from tax-loss harvesting would be pure profit (because her heirs will receive the fund’s current market value as their cost basis when they inherit it).

When to Tax-Loss Harvest

Many investors check for tax-loss harvesting opportunities right before the end of the year — when they start thinking about taxes. While that’s perfectly fine, it can be advantageous to check several times throughout the year. Investments can be volatile, and it’s entirely possible that a tax-loss harvesting opportunity will arise early in the year, only to disappear before year-end.

Potential Pitfall: The Wash Sale Rule

The place where people often trip up is by accidentally triggering the “wash sale” rule. A wash sale occurs when you:

  1. Sell an investment for a loss, and
  2. Buy “substantially identical” securities within 30 days before or after the sale.

When a wash sale occurs, the loss is disallowed. Fortunately, the cost basis of your new shares is adjusted upward by an amount equal to the disallowed loss so that when you sell the shares in the future — assuming you don’t trigger the wash sale rule yet again — you’ll be able to claim the loss (or, depending on circumstances, a smaller capital gain).

Example: Catherine buys 100 shares of a stock at $38 per share. A few months later, Catherine sells the shares for $25 per share. Five days later, she buys another 100 shares of the same stock at $29 per share. Because she bought new shares within 30 days of the sale, the wash sale rule will be triggered, and Catherine’s loss of $13 per share will be disallowed. Her cost basis in the new shares, however, will be $42 per share ($29 purchase price + $13 from the disallowed loss), thereby allowing for a larger capital loss or smaller capital gain when she sells the shares in the future.

Wash Sales Due to a Spouse’s Transactions

Some investors hope to avoid the wash sale rule by having their spouse buy a particular investment at the same time that they sell it for a loss. But, as explained in IRS Publication 550this does not work. For the purpose of triggering a wash sale, your spouse buying or selling an investment has the same effect as you buying or selling the investment.

Wash Sales Due to Buying in an IRA

Other investors try to avoid a wash sale by selling an investment for a loss in their taxable account, then buying the same investment in their IRA — with the idea being that the IRA is titled differently than the taxable account, so it would not trigger a wash sale.

This doesn’t work either. Buying a “substantially identical” investment in your IRA (whether Roth or traditional) within 30 days of the sale will result in a wash sale.

Wash Sales Due to Buying Within 30 Days Prior to Sale

Finally, many investors think of wash sales as only occurring if you re-buy the investment shortly after selling it. That is, they forget that a wash sale can occur if you buy shares within 30 days prior to the sale.

Example: On January 1, Josh buys 100 shares of Vanguard Total Stock Market ETF in his brokerage account for $60 per share. On January 15, Josh buys another 100 shares for $58 per share. On January 20, Josh sells 100 shares, at a price of $56 per share. Josh has a wash sale. His loss will be disallowed and added to the cost basis of his remaining 100 shares.

Note, however, that you do not need to worry about wash sales if you liquidate all of your shares of a given investment and you do not repurchase substantially identical securities within 30 days.

Example: On January 1, Lucy buys 100 shares of Vanguard Total Stock Market ETF in her brokerage account, at a price of $60 per share. On January 10, Lucy sells her 100 shares for $55 per share, and she does not purchase substantially identical securities in any of her accounts within the next 30 days. Lucy will be able to claim her loss of $5 per share, despite the fact that a purchase occurred within 30 days prior to the sale.

Wash Sales from Buying in a 401(k)

Update: A few readers asked whether a wash sale can be triggered when, after selling an investment for a loss in a taxable account, substantially identical securities are purchased in a 401(k) or 403(b).

This answer is a bit trickier. Section 1091 of the Internal Revenue Code is the law that creates the wash sale rule. It doesn’t mention retirement accounts at all. The rule about wash sales being triggered from purchases in an IRA comes from IRS Revenue Ruling 2008-5. If you read through the ruling, you’ll see that it speaks specifically to IRAs and does not mention 401(k) or other employer-sponsored retirement plans.

To the best of my knowledge, there is no official IRS ruling that speaks specifically to wash sales being created by a transaction in a 401(k). In other words, I’m not aware of any source of legal authority that clearly says that a purchase in a 401(k) would trigger a wash sale.

However, in my opinion, it seems pretty clear that the line of reasoning in the above-linked revenue ruling would apply to employer-sponsored retirement plans as well as IRAs.

So, personally, I would not be comfortable taking a position on a tax return that’s based on the assumption that purchases in a 401(k) cannot trigger a wash sale. But that’s just my personal opinion. Others may disagree.

What Makes Two Mutual Funds “Substantially Identical”?

Update #2: Several readers also wrote in with questions about how to know whether two mutual funds are “substantially identical” for the purposes of triggering a wash sale.

Unfortunately, I’m not aware of any official IRS position providing a cut-and-dried test to determine whether two mutual funds are substantially identical. From what I gather, challenging people on the wash sale rule is just not a top priority from a tax enforcement standpoint.

Personally, my standard is this: If the IRS did challenge my position, and I ended up in court having to make the case that these two funds were not substantially identical, would I feel confident about my chance of success? Unless the answer is “yes, absolutely,” I’d choose a different (less similar) mutual fund.

For example, I would not be comfortable making the case that the following are not substantially identical:

  • The ETF version and the mutual fund version of a given Vanguard index fund,
  • Two index funds or ETFs that track the same index (even if their holdings are not identical), or
  • Two “total market” index funds, even if they track slightly different indexes.

In short, I would probably not want to use a given fund as a tax loss harvesting partner for another fund unless I could not only show that the underlying portfolios are different, but also provide a chart showing that the two funds really do perform noticeably differently. But, as with the previous question, this is one in which other people could rationally reach a different conclusion.

Finally, as author Taylor Larimore often reminds investors at the Bogleheads forum: If you want to tax loss harvest with a particular fund, and you don’t want to worry about finding a replacement fund that’s similar but not substantially identical, you can always just wait 31 days after the sale, then re-buy the original fund.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Tax Deduction and Credits for College Expenses

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

Given that the tax law is (usually) set up to reward things that Congress has decided are beneficial to our country, it’s no surprise that there are tax breaks available to people paying for higher education expenses.

Education Credits

If you pay higher education expenses for yourself, your spouse, or your dependent, you may be entitled to one (or both) of two credits: the Lifetime Learning Credit or the American Opportunity Credit.

Lifetime Learning Credit

The Lifetime Learning Credit may be available to you if you pay postsecondary education expenses for a student. The credit is calculated as 20% of the first $10,000 of qualified education expenses that you pay in a given year. (Note that this means that the maximum credit per tax return is $2,000.)

Your eligibility to claim the Lifetime Learning Credit begins to decrease as your modified adjusted gross income exceeds $58,000 for 2019 ($116,000 if married filing jointly). Once your MAGI reaches $68,000 ($136,000 if married filing jointly), you’ll no longer be eligible to use the credit.

There is no limit to the number of years that the Lifetime Learning Credit can be used for a given student.

In order to qualify for the Lifetime Learning Credit, the expenses must be paid to a university, college, vocational school, or other postsecondary educational institution. Eligible expenses include tuition, fees, and other course-related expenses that are required to be paid to the institution as a condition for enrollment or attendance. The course must be part of a postsecondary degree program or taken by the student to acquire or improve job skills.

EXAMPLE: Jack is attending school to be a filmmaker. In addition to his tuition, he’s required to pay $500 per semester for use of the school’s film studio. Because he is required to pay the $500 to the school in order to attend classes, the expense can be included as a qualifying education expense.

EXAMPLE: Lee is attending school for a degree in Spanish. Each semester, he is required to buy several textbooks and DVDs to use for his courses. However, because his school doesn’t require him to buy the materials from the school — he could buy them online on Amazon, for instance — the cost does not count as a qualifying education expense.

Two more points of note about qualifying expenses:

  1. Room and board does not count as a qualifying education expense.
  2. It doesn’t matter whether or not the money used to pay the expenses was obtained with a loan.

American Opportunity Credit

The American Opportunity Credit is available for students who are in their first four years of postsecondary education and who are enrolled at least “half-time.” The amount of the credit is the sum of the first $2,000 of qualified education expenses paid for the student, plus 25% of the next $2,000 of qualified expenses. (Note that this means that the maximum credit per student is $2,500.)

Your eligibility to claim the American Opportunity Credit begins to decrease as your modified adjusted gross income exceeds $80,000 ($160,000 if married filing jointly). Once your MAGI reaches $90,000 ($180,000 if married filing jointly), you’ll no longer be eligible to use the credit.

In addition to the expenses that can be used when calculating the Lifetime Learning Credit, expenditures for “course materials” can be used for purposes of calculating the American Opportunity Credit. “Course materials” includes books and supplies needed for a course, whether or not the materials are purchased from the educational institution as a condition of enrollment or attendance.

How the Credits Work Together

For a given student, you can claim either the Lifetime Learning Credit or the American Opportunity Credit in a given year, not both.

EXAMPLE: Katie and Alex are siblings. Alex is a freshman in college, and Katie is a senior (in her fifth year of college). With the help of some student loans, their family spends $20,000 for tuition for each of them for the year.

The family should probably claim the American Opportunity Credit for Alex, because it will allow for a credit of $2,500, as opposed to the $2,000 that would be allowed via the Lifetime Learning Credit. Also, by not using the Lifetime Learning Credit for Alex, the family can still use the Lifetime Learning Credit for Katie. (Katie is ineligible for the American Opportunity Credit, because she is in her fifth year of college.) In total, the family will be able to claim $4,500 of education-related credits.

Student Loan Interest Deduction

If you pay interest on student loans, you may be able to deduct that interest (up to $2,500 per year) as an “adjustment to income” (sometimes referred to as an “above the line” deduction). In order to qualify:

  1. The loan must be taken out solely to pay for qualified higher education expenses,
  2. You (and your spouse, if you’re married) must not be claimed as a dependent on another person’s return, and
  3. If married, you must file jointly.

The $2,500 limit for the deduction is reduced as your modified adjusted gross income exceeds (for 2019) $70,000 ($140,000 if married filing jointly). Once your modified adjusted gross income reaches $85,000 ($170,000 if married filing jointly), you will no longer be eligible for the deduction.

Simple Summary

  • If you pay postsecondary education expenses for yourself, your spouse, or your dependent, you may be eligible for the Lifetime Learning Credit (of up to $2,000). Only one Lifetime Learning Credit can be claimed per tax return per year.
  • If you pay higher education expenses for yourself, your spouse, or your dependent, you may be eligible to claim the American Opportunity Credit (of up to $2,500 per student).
  • For a given student’s expenses each year, you can use either the American Opportunity Credit or the Lifetime Learning Credit, not both.
  • If you pay student loan interest, you may qualify for a deduction for the amount of interest paid, up to $2,500.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

The Difference Between Exemptions, Deductions, and Credits

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

In short, the difference between deductions, exemptions, and credits is that deductions and exemptions both reduce your taxable income, while credits reduce your tax.

Exemptions

Important note: for 2018-2025, exemptions will no longer exist. (This is one of the big changes from the new tax law that took effect in 2018.)

For 2017, you were entitled to an exemption of $4,050 for yourself, one for your spouse, and one for each of your dependents.

EXAMPLE: Kevin and Jennifer are married, with a combined income of $80,000 in 2017. They have four children, whom they claimed as dependents. They were allowed six exemptions of $4,050 each. As a result, their 2017 taxable income was reduced by $24,300.

Deductions

Deductions generally arise from your expenses. For example, a deduction is allowed for interest paid on student loans.

EXAMPLE: Carlos is in the 12% tax bracket. Over the course of the year, he paid $2,000 in student loan interest. This $2,000 decrease in his taxable income will save him $240 in taxes ($2,000 x 12%).

Types of Deductions

Deductions are often grouped into two categories:

  1. “Adjustments to income” and
  2. “Itemized” deductions.

Every year, you can claim all of the adjustments to income for which you qualify, as well as:

  1. The itemized deductions for which you qualify, or
  2. A fixed amount known as the “standard deduction.” (In 2019, the standard deduction is $12,200 for a single taxpayer or $24,400 for a married couple filing jointly.)

Here’s how it looks mathematically:

Total income (sum of all your income)
“Adjustment to income” deductions
=  Adjusted gross income
Standard deduction or itemized deductions
=  Taxable income

A key point here is that adjustments to income are always valuable, whereas itemized deductions are only valuable if and to the extent that they (in total) exceed your standard deduction amount. That is, if your itemized deductions in a given year are less than the standard deduction you’ll simply claim the standard deduction in that year rather than using your itemized deductions. And your itemized deductions will therefore not provide you with any tax savings.

Some common adjustments to income include contributions to a traditional IRA, contributions to a Health Savings Account (HSA), and interest paid on student loans.

Common itemized deductions include charitable contributions, the interest on a home mortgage, and medical/dental expenses.

EXAMPLE: Eddie is a single taxpayer. During the year he contributes $3,000 to a traditional IRA, and he makes a charitable contribution of $1,000 to the Red Cross. He has no other deductions, and his income (before deductions) is $50,000.

The IRA contribution is an above the line deduction, and the charitable donation is an itemized deduction. Using our equation from above, we get this:

$50,000 Total income
$3,000 Adjustments to income
= $47,000 Adjusted gross income
$12,200 Standard deduction
= $34,800 Taxable income

Important observations:

  1. Eddie’s itemized deductions ($1,000) are less in total than his standard deduction ($12,200). As such, Eddie’s charitable contribution doesn’t provide him with any tax benefit, because he’ll elect to use his standard deduction instead of his itemized deductions.
  2. Eddie’s adjustment to income provides a tax benefit even though he’s using the standard deduction.

Again, itemized/below the line deductions only help when they add up to an amount greater than your standard deduction. Adjustments to income, on the other hand, are always beneficial.

Credits

Unlike deductions, credits reduce your taxes directly, dollar for dollar. After determining the total amount of tax you owe, you then subtract the dollar value of the credits for which you are eligible. This makes credits particularly valuable.

Credits arise from a number of things. Most often, they are the result of the taxpayer doing something that Congress has decided is beneficial for the community. For example, you are allowed a credit of up to $2,500 for paying “qualified education expenses” for one of your dependents. If you meet the requirements to claim the maximum credit, your tax (not taxable income) will be reduced by $2,500.

“Pre-Tax Money”

You’ll often hear the term “pre-tax money,” generally used in a context along the lines of, “You can pay for [something] with pre-tax money.” This means one of two things:

  1. The item is deductible, or
  2. The item can be paid for automatically in the form of a payroll deduction.

The reason these situations are sometimes referred to as “pre-tax” is that you get to spend this money before the government takes its cut. This makes it more cost-effective for you.

You may, from time to time, run across people who are under the impression that something is free simply because it’s deductible or because they were allowed to spend pre-tax money on it. This is a severe misunderstanding. Being able to spend pre-tax money on something is more akin to getting a discount on it than it is to getting the item for free.

Simple Summary

  • Deductions reduce your taxable income. Aside from the standard deduction, deductions generally arise from your expenses.
  • Each year, you can use either your standard deduction or the sum of all your itemized deductions.
  • “Adjustment to income” deductions are particularly valuable because you can use them regardless of whether you use your standard deduction or itemized deductions.
  • Credits, unlike deductions, reduce your tax directly (as opposed to reducing your taxable income). Therefore, a credit is more valuable than a deduction of the same amount.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

How Social Security Benefits Are Calculated

The following is an excerpt from my book Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less.

The size of your monthly retirement benefit depends on:

  1. Your earnings history, and
  2. How old you are when you first begin taking benefits.

But first we need to back up a step. In order to understand how Social Security benefits are calculated, you need to be familiar with two terms:

  • “full retirement age” (FRA), and
  • “primary insurance amount” (PIA).

Your full retirement age depends on the year in which you were born (see table below). Your primary insurance amount is the amount of retirement benefits you would receive per month if you started taking them at your full retirement age. As we’ll discuss shortly, your PIA is determined by your earnings history.

Year of Birth Full Retirement Age
1937 or earlier 65
1938 65 and 2 months
1939 65 and 4 months
1940 65 and 6 months
1941 65 and 8 months
1942 65 and 10 months
1943-1954 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 or later 67

How Earnings History Affects Retirement Benefits

Your primary insurance amount is based on your historical earnings. Specifically, it’s based on your “average indexed monthly earnings” (AIME). Calculating your AIME is a five-step process.

  1. Make a year-by-year list of your earnings, excluding any earnings for each year that were in excess of the maximum amount subject to Social Security tax.
  2. Adjust your earnings from prior years to today’s dollars.
  3. Select your 35 highest-earning years.
  4. Add up the total amount of earnings in those 35 years.
  5. Divide by 420 (the number of months in 35 years).

You do not actually have to do this calculation yourself. The Social Security Administration does it for you. It is, however, important to understand the concept, so that you can understand how your benefit is calculated.

Calculating Your Primary Insurance Amount

For someone becoming eligible for retirement benefits (that is, reaching age 62) in 2019, his or her primary insurance amount would be:

  • 90% of any AIME up to $926, plus
  • 32% of any AIME between $926 and $5,583, plus
  • 15% of any AIME above $5,583.

Note that these figures change to account for wage inflation each year. So, for example, for somebody turning age 62 in 2020, each of these dollar amounts will probably be slightly higher.

Or, to put it in terms of annual income, if claimed at full retirement age, Social Security would replace:

  • 90% of the first $11,112 of average annual wage-inflation-adjusted earnings, plus
  • 32% of average annual wage-inflation-adjusted earnings from $11,112 to $66,996, plus
  • 15% of average annual wage-inflation-adjusted earnings from $66,996 to $123,552.

Two noteworthy takeaways here are that:

  1. Social Security replaces a higher portion of wages for lower-earning workers than for higher-earning workers, and
  2. There’s a maximum possible Social Security retirement benefit. (Few people reach that maximum though, because doing so would require that you earn the maximum earnings subject to Social Security tax for 35 different years.)

If You Worked Fewer than 35 Years

If you have fewer than 35 years in which you earned income subject to Social Security taxes, the calculation of your average indexed monthly earnings will include zeros. For example, if you worked for 31 years, your AIME calculation would include those 31 years of earnings, as well as 4 years of zeros.

As a result, working additional years would result in those zero-earnings years being knocked out of the calculation and replaced with your current earnings. The result isn’t going to make you rich, but it’s worth including in your list of considerations when deciding when to retire.

How Age Affects Retirement Benefits

If you wait until after full retirement age to claim your retirement benefit, the amount you receive will be greater than your primary insurance amount. The increase is 2/3 of 1% for each month you wait beyond full retirement age (up to age 70, beyond which there is no increase for waiting). This works out to an increase of 8% per year.

EXAMPLE: Alan was born in 1954, so his full retirement age is 66. His primary insurance amount is $2,000. If he waits until age 70 (that is, 48 months after FRA) to claim his retirement benefit, he will receive $2,640 per month, calculated as:

  • His PIA of $2,000 per month, plus
  • 2/3 of 1% x 48 months x $2,000.

If you claim your retirement benefit prior to full retirement age, it will be reduced from your primary insurance amount by 5/9 of 1% for each month (up to 36 months) prior to full retirement age. This works out to a reduction of 6.67% per year. For each month in excess of 36 months, the reduction is 5/12 of 1% (or 5% per year).

EXAMPLE: Allison was born in 1960, so her full retirement age is 67. Her primary insurance amount is $2,000. If she claims retirement benefits at age 65 (24 months prior to FRA), her monthly benefit would be $1,733.33, calculated as:

  • Her PIA of $2,000 per month, minus
  • 5/9 of 1% x 24 months x $2,000.

If Allison decides instead to claim at age 62 (60 months prior to FRA), her benefit would be $1,400 per month, calculated as:

  • Her PIA of $2,000 per month, minus
  • 5/9 of 1% x 36 months x $2,000, minus
  • 5/12 of 1% x 24 months x $2,000.

In short, the interaction between the size of your retirement benefits and the age at which you first claim that benefit looks like this:

Age when you claim retirement benefits Amount of retirement benefit
5 years before FRA 70% of PIA
4 years before FRA 75% of PIA
3 years before FRA 80% of PIA
2 years before FRA 86.67% of PIA
1 year before FRA 93.33% of PIA
at FRA 100% of PIA
1 year after FRA 108% of PIA
2 years after FRA 116% of PIA
3 years after FRA 124% of PIA
4 years after FRA 132% of PIA

Adjusting Benefits for Inflation

Every year after you reach age 62, your primary insurance amount is adjusted to keep up with inflation as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). When your PIA is adjusted upward for inflation, it increases not only your retirement benefit, but also any other benefits that are based on your PIA (e.g., your spouse’s spousal benefits).

Simple Summary

  • Your “primary insurance amount” (PIA) is the monthly retirement benefit you would receive if you claimed benefits at “full retirement age” (FRA).
  • Your primary insurance amount is calculated based on your 35 highest-earning years (after adjusting prior years’ earnings for wage inflation).
  • If you claim retirement benefits prior to your full retirement age, you will receive an amount smaller than your PIA. If you wait until after your full retirement age to claim benefits, your retirement benefit will be greater than your PIA.
  • Social Security benefits are adjusted on an annual basis to keep up with inflation (as measured by the CPI-W).

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

How is Social Security Taxed?

The following is an excerpt from my book Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less.

Each year, the portion of your Social Security income that’s subject to federal income tax depends on your “combined income.” Your combined income is equal to:

  • Your adjusted gross income (which you can find at the bottom of the first page of your Form 1040), not including any Social Security benefits, plus
  • Any tax-exempt interest you earned, plus
  • 50% of your Social Security benefits.

If your combined income is below $25,000 ($32,000 if married filing jointly), none of your Social Security benefits will be taxed.

For every dollar of combined income above that level, $0.50 of benefits will become taxable until 50% of your benefits are taxed or until you reach $34,000 of combined income ($44,000 if married filing jointly).

For every dollar of combined income above $34,000 ($44,000 if married filing jointly), $0.85 of Social Security benefits will become taxable — all the way up to the point at which 85% of your Social Security benefits are taxable.*

Important note: To say that 85% of your Social Security benefits are taxable does not mean that 85% of your benefits will disappear to taxes. Rather, it means that 85% of your benefits will be included as taxable income when determining your total income tax for the year.

How Does This Affect Tax/Retirement Planning?

The big takeaway of the above calculations is that, once you start collecting Social Security, your marginal tax rate (that is, the total tax rate you would pay on each additional dollar of income) often increases dramatically. That’s because, if your “combined income” is in the applicable range, each additional dollar of income is not only taxed at your regular tax rate, it also causes an additional $0.50 or $0.85 of Social Security benefits to be taxable.

This dramatic change in your marginal tax rate often creates significant tax planning opportunities.

For example, if you haven’t yet begun to collect Social Security and you realize that your marginal tax rate will increase once you do, you may benefit from funding most of your current spending via withdrawals from tax-deferred accounts (as opposed to taxable accounts or Roth accounts), thereby allowing the withdrawals to be taxed at your current, relatively-lower tax rate, and thereby preserving your Roth accounts for funding spending needs in the future when your tax rate will be higher.

Or you might even want to take it one step further by converting a portion of your traditional IRA(s) to a Roth IRA in the years of retirement prior to collecting Social Security.

Or, if you are already collecting Social Security, once your combined income nears the range where Social Security benefits will start to become taxable, you may want to fund the rest of your spending (to the extent possible) with assets not from tax-deferred accounts (so as to stay below the range where your benefits would become taxable).

Alternatively, if your combined income is already near the high end of the range in question (such that most or all of your benefits are 85% taxable), it may make sense to withdraw more from your tax-deferred accounts (perhaps just enough to put you up to the top of your current tax bracket) so that you can withdraw less next year, thereby allowing you to stay in the range where your benefits will not be taxable.

Simple Summary

  • Depending on how high your “combined income” is in a given year, your Social Security benefits could be nontaxable or partially taxable (with a maximum of 85% of them being included in your taxable income for the year).
  • If it looks like your marginal tax rate is going to increase sharply once you start collecting Social Security, it may make sense — in the years prior to collecting Social Security — to fund much of your spending from tax-deferred accounts (and potentially execute Roth IRA conversions) to take advantage of the fact that your tax rate is lower than it will be in the future.
  • Once you start collecting Social Security, you may be able to reduce your overall tax bill by carefully planning which accounts you spend from each year (tax-deferred as opposed to Roth as opposed to taxable) so as to minimize the portion of your Social Security benefits that will be taxable.

*These are the general rules. As with so many aspects of the tax code, there are exceptions. For more information, see IRS Publication 915.

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  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
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Capital Gains and Losses: Short-Term and Long-Term

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

When you sell something (such as a share of stock) for more than you paid for it, you’re generally going to be taxed on the increase in value. This increase in value is known as a “capital gain.”

The amount of gain is calculated as the proceeds received from the sale, minus your “cost basis” in the asset.

What is “Cost Basis”?

In most cases, your cost basis in an asset is simply the amount that you paid for that asset, including any brokerage commissions that you paid on the transaction.

EXAMPLE: Lauren buys a share of Google stock for $250, including brokerage commissions. She owns it for two years and then sells it for $400. Her cost basis is the amount she paid for it: $250. Her gain will be calculated as follows:

$400 (proceeds from sale)
$250 (adjusted cost basis)
= $150 (capital gain)

Long-Term Capital Gains vs. Short-Term Capital Gains

The rate of tax charged on a capital gain depends upon whether it was a long-term capital gain (LTCG) or a short-term capital gain (STCG). If the asset in question was held for one year or less, it’s a short-term capital gain. If the asset was held for greater than one year, it’s a long-term capital gain.

STCGs are taxed at normal income tax rates. In contrast, LTCGs, are taxed at the same rates as qualified dividend income.

That is, for 2019, LTCGs are taxed at a 0% rate if they fall below $39,375 of taxable income ($78,750 if you’re married filing jointly). They are taxed at a 15% rate if they fall above the 0% threshold but below $434,550 ($488,850 if married filing jointly). And they are taxed at a 20% rate if they fall above the 15% threshold.

An important takeaway here is that if you’re ever considering selling an investment that has increased in value, it might be a good idea to think about holding the asset long enough for the capital gain to be considered long-term.

Note that a capital gain occurs only when the asset is sold. This is important because it means that fluctuations in the value of the asset are not considered taxable events.

EXAMPLE: Beth buys ten shares of Honda Motor Company at $25 each. Five years later, Beth still owns the shares, and the price per share has risen to $45. Over the five years, Beth isn’t required to pay any tax on the increase in value. She will only have to pay a tax on the LTCG if/when she chooses to sell the shares.

Taxation of Mutual Funds

Mutual funds are collections of a large quantity of other investments. For instance, a mutual fund may own thousands of different stocks as well as any number of other investments like bonds or options contracts.

Each year, each mutual fund shareholder is responsible for income tax on her share of the net capital gains realized by the fund over the course of the year. (Each shareholder’s portion of the gains will be reported to her annually on Form 1099-DIV sent by the brokerage firm or fund company.)

What makes the situation counterintuitive is that, in any given year, the capital gains realized by the fund could vary significantly from the actual change in value of the shares of the fund.

EXAMPLE: Deborah buys a share of Mutual Fund XYZ on January 1 for $100. By the end of the year, the investments that the fund owns have (on average) decreased in value, and Deborah’s share of the mutual fund is now worth $95.

However, during the course of the year, the mutual fund sold only one stock from the portfolio. That stock was sold for a short-term capital gain. Deborah is going to be responsible for paying tax on her share of the capital gain, despite the fact that her share in the mutual fund has decreased in value.

Note how even in years when the value decreases, it’s possible that the investors will be responsible for paying taxes on a gain. Of course, the opposite is also true. There can be years when the fund increases in value, but the sales of investments within the fund’s portfolio result in a net capital loss. And thus the investors have an increase in the value of their holdings, but they don’t have to pay any taxes for the time being.

Capital Gains from Selling Your Home

Selling a home that you’ve owned for many years can result in a very large long-term capital gain. Fortunately, it’s likely that you can exclude (that is, not pay tax on) a large portion — or even all — of that gain.

If you meet three requirements, you’re allowed to exclude up to $250,000 of gain. The three requirements are as follows:

  1. For the two years prior to the date of sale, you did not exclude gain from the sale of another home.
  2. During the five years prior to the date of sale, you owned the home for at least two years.
  3. During the five years prior to the date of sale, you lived in the home as your main home for at least two years.

To meet the second and third requirements, the two-year time periods do not necessarily have to be made up of 24 consecutive months.

For married couples filing jointly, a $500,000 maximum exclusion is available if both spouses meet the first and third requirements and at least one spouse meets the second requirement.

EXAMPLE: Jason purchased a home on January 1, 2017. He lived there until May 1, 2018 (16 months). He then moved to another city (without selling his original home) and lived there until January 1, 2019. On January 1, 2019 Jason moved back into his original home and lived there until October 1, 2019 (9 months) when he sold the house for a $200,000 gain.

Jason can exclude the gain because he meets all three requirements. The fact that Jason does not have 24 consecutive months of using the home as his main home does not prevent him from excluding the gain.

Capital Losses

Of course, things don’t always go exactly as planned. When you sell something for less than you paid for it, you incur what is known as a capital loss. Like capital gains, capital losses are characterized as either short-term or long-term, based on whether the holding period of the asset was greater than or less than one year.

Each year, you add up all of your short-term capital losses, and deduct them from your short-term capital gains. Then you add up all of your long-term capital losses and deduct them from your long-term capital gains. If the end result is a positive LTCG and a positive STCG, the LTCG will be taxed at a maximum rate of 20%, and the STCG will be taxed at ordinary income tax rates. If the end result is a net capital loss, you can deduct up to $3,000 of it from your ordinary income. The remainder of the capital loss can be carried forward to deduct in future years.

EXAMPLE 1: In a given year, Aaron has:
$5,000 in short-term capital gains,
$3,000 in short-term capital losses,
$4,000 in long-term capital gains, and
$2,500 in long-term capital losses.

For the year, Aaron will have a net STCG of $2,000 ($5,000-$3,000) and a net LTCG of $1,500 ($4,000-$2,500). His STCG will be taxed at his ordinary income tax rate, and his LTCG will be taxed at a maximum rate of 20%.

EXAMPLE 2: In a given year, Sandra has:
$2,000 in short-term capital gains,
$3,500 in short-term capital losses,
$3,000 in long-term capital gains, and
$5,000 in long-term capital losses.

Sandra has a net short-term capital loss of $1,500 and a net long-term capital loss of $2,000. So her total capital loss is $3,500. For this capital loss, she can take a $3,000 deduction against her other income, and she can use the remaining $500 to offset her capital gains next year.

So what happens when you have a net gain in the short-term category and a net loss in the long-term category, or vice versa? In short, you net the two against each other, and the remaining gain or loss is taxed according to its character (that is, short-term or long-term).

EXAMPLE 1: In a given year, Kyle has:
$5,000 net short-term capital gain and
$4,000 net long-term capital loss.

Kyle will subtract his LTCL from his STCG, leaving him with a STCG of $1,000. This will be taxed according to his ordinary income tax bracket.

EXAMPLE 2: In a given year, Christopher has:
$3,000 net short-term capital loss and
$6,000 net long-term capital gain.

Christopher will subtract his STCL from his LTCG, leaving him with a LTCG of $3,000. This will be taxed at a maximum of 20%.

EXAMPLE 3: In a given year, Jeremy has:
$2,000 net short-term capital gain and
$3,000 net long-term capital loss.

Jeremy will subtract his LTCL from his STCG, leaving him with a $1,000 LTCL. Because this is below the $3,000 threshold, he can deduct the entire $1,000 loss from his ordinary income.

EXAMPLE 4: In a given year, Jessica has:
$2,000 net long-term capital gain and
$4,000 net short-term capital loss.

Jessica will subtract her STCL from her LTCG, leaving her with a $2,000 STCL. Because this is below the $3,000 threshold, she can deduct the entire $2,000 loss from her ordinary income.

Simple Summary

  • If an asset is held for one year or less, then sold for a gain, the short-term capital gain will be taxed at ordinary income tax rates.
  • If an asset is held for more than one year, then sold for a gain, the long-term capital gain will be taxed at a maximum rate of 20%.
  • If you have a net capital loss for the year, you can subtract up to $3,000 of that loss from your ordinary income. The remainder of the loss can be carried forward to offset income in future years.
  • Mutual fund shareholders have to pay taxes each year as a result of the net gains incurred by the fund. This is unique in that taxes have to be paid before the asset (i.e., the mutual fund) is sold.
  • If you sell your home for a gain, and you meet certain requirements, you may be eligible to exclude up to $250,000 of the gain ($500,000 if married filing jointly).

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

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