Not So Golden Years: Rise in Capital Gains and Dividends Tax Would Hit Seniors Hard

The baby boomers' nest egg will soon start to crack if the Bush tax cuts are allowed to expire. 

Retired seniors could be among the hardest hit by the failure to extend Bush-era tax cuts on Jan. 1 since they rely most on investments and savings 

Lawmakers have been warning for months about the income-tax consequences for working families, including penalties on marriage and a reduction in child tax credits. 

But those living off investment income would see not only their 401(k) and savings accounts taxed at higher income rates, but also dividends and capital gains skimmed deeper and deeper by the federal government. 

Studies of IRS data put out by The Tax Foundation show seniors over 65 earn more from dividends and capital gains than any other age group -- more than $77 billion in dividends and more than $150 billion in capital gains in 2008. 

That means for retired workers, every penny is that much more valuable. Investment income typically supplements Social Security, or vice versa, and tax analysts say that if the Bush tax cuts expire, it could mean thousands of dollars less every golden year. 

Pete Sepp, executive vice president at the National Taxpayers Union, called it a "serious tax squeeze" for retirees. 

"A lot of them still have money in things like traditional mutual funds," he said. 

Here's what happens to that income if tax rates increase to levels of almost a decade ago: 

On the capital gains side, the hit would be somewhat modest. Currently, the lowest rate for long-term gains is 0 percent and the highest is 15 percent. If nothing is changed, the lowest rate rises to 10 percent, the highest to 20 percent. 

The change on the dividends side is far more drastic, since it used to be taxed as ordinary income. Barring congressional intervention, the lowest rate for qualified dividends goes from 0 to 15 percent and the highest goes from 15 to 39.6 percent. Even those in the middle-class brackets could expect to see their rate rise to close to 30 percent. 

Sepp said seniors in the upper-class brackets "have a lot to worry about" in that scenario, but that even a couple taking in $25,000 from interest and dividends would easily see their taxes go up by more than $2,000. 

And that would mean much more than less money for groceries, dinner and the movies. It also could have ramifications for state and local economies -- like Florida's -- where seniors make up a huge portion of the population. 

"We know they'll spend less because they'll have less to spend," said Bill Ahern, spokesman for The Tax Foundation. "I would expect the restaurant sector, the entertainment sector to suffer." 

Dozens of House Democrats warned in a letter to Speaker Nancy Pelosi last month that the increases could "discourage" other Americans from investing. 

"Raising the tax rate on dividends would likely cause some companies to forego paying dividends and others to pay a lower amount to shareholders," they wrote, urging Congress to extend the current rates. "These outcomes would disproportionately affect seniors and those saving for retirement." 

Despite the standoff, President Obama and congressional leaders on both sides of the aisle say they're intent on extending at least some of the tax cuts -- unfinished business to be taken up after the election. Republicans want all the rates extended, while Obama wants the rates extended for all but the wealthiest earners. Under the Obama plan, the top-bracket capital gains and dividends rates would rise to 20 percent. 

Sepp said he doesn't expect Congress to allow dividends to be taxed as ordinary income, considering how significant the change would be. 

But even if Democrats get their way, Ahern noted that an increase from 15 to 20 percent is still considerable for someone living off that income. 

"A 33 percent tax hike on your dividend income ... is economically significant," Ahern said. 

A 5-point hike in the capital gains tax is particularly significant for homeowners looking to sell their property. 

Sepp also noted that it's unclear whether Congress would keep the 0 percent rate at the bottom end, given that the lowest rate only recently dropped to nothing from 5 percent. 

"That could very easily be dealt away," Sepp said.