Retirees: The Tax Bracket Rule That Determines Whether Capital Gains Are Taxed at 0%, 15% or 20%

Retirement can be complicated enough on its own, whether you are planning ahead or already living on post-career income. For many retirees, an investment portfolio can introduce another layer of questions.

One tax rule that often gets overlooked involves long-term capital gains, or LTCGs. These are different from short-term capital gains on assets held for 12 months or less, which are taxed as ordinary income at your regular bracket rate.

Long-term capital gains receive preferential federal rates of 0%, 15% or 20%, depending on where the income falls.

It is important to remember that ordinary income fills the lowest tax brackets first, and long-term capital gains are stacked on top of that amount. Ordinary income includes wages, 1099 income, short-term investment gains, interest, and distributions or withdrawals from taxable retirement accounts such as IRAs or 401(k)s.

Higher-income retirees should also keep the Net Investment Income Tax, or NIIT, in mind. This 3.8% federal surtax applies to net investment income once income crosses $200,000 for single filers or $250,000 for married couples filing jointly.

Income Valleys Can Lower Taxes, But Not Everyone Can Use Them

Another question is whether retirees actually have an opening to benefit from what is often called an income valley.

Fidelity notes that retirees may experience an income valley in the years after leaving work if they are no longer receiving regular wages and if Social Security, pension income, and retirement-account withdrawals are either not yet started or still relatively small.

In those situations, it can make sense to draw from investment accounts in a way that fills unused room in the 0% bracket, allowing some long-term capital gains to be realized without federal tax.

That opportunity tends to narrow over time. Once Social Security is no longer being delayed, the income valley typically shrinks, and when required minimum distributions from eligible accounts begin at age 73, the chance to take advantage of that gap becomes much smaller.

State Taxes Can Change the Outcome

Retirees should also remember that realizing long-term capital gains can increase adjusted gross income, or AGI. That can affect how much of your Social Security benefit becomes taxable. In other words, even if the gains themselves are federally tax-advantaged, a higher AGI may still cause more of your benefits to be included in taxable income.

State taxes are another factor. Oregon, New York and California do not provide special treatment for this type of income, and California taxes capital gains as ordinary income at rates as high as 13.3%. By contrast, states without an income tax — including Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming — do not tax long-term capital gains.