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 is a spreadsheet which graphically shows how the taxation of your Social Security (SS) benefits will affect your retirement tax rates.

Overview
This tax impact calculator works on the principle of the old cliché: a picture is worth a thousand words!

This is an illustration of exactly what this article is all about. The red line illustrate the taxes paid when all of your income comes from ordinary sources. The blue line illustrates the taxes paid on the same income stream where $30,000 comes from Social Security, $6,000 comes from Long Term Capital Gains, and the rest from ordinary income sources. The dotted green line is the purpose of this article. It illustrates your tax savings and how, during retirement, those savings can grow in this case up to $4,642, then shrink back to only $1,725 as you give $2,917 back to the IRS as your initially tax free LTCG and Social Security slowly becomes taxable income. If you know that you will have to give back the tax savings and when that will happen, maybe you can modify your investments and keep the savings. The interesting thing here is that your broker can’t talk to you about taxes and your tax accountant can’t talk to you about investments. Neither one will show you this picture, it had to come from a computer geek on the Internet. On top of all that, the computer geek is not “qualified” to give advice on either topic, but you can download the spreadsheet, enter your personal financial data and create the graph or your own personal “Marginal” tax rates then show that graph to your accountant and broker as a reference on the type of advice you need. They are allowed to verify if the graph looks reasonable, they just can’t create it for you.

Throughout this article we will be referring to The Hump and how to avoid it. The Hump is a range of your retirement income where your Federal Marginal Tax Rate can jump to 55.5%. It was created by the 1993 amendment to the Social Security Act that made an additional 85 cents of your Social Security benefit taxable income for every $1 of additional taxable income you receive.

Once you reach the 25% Tax Bracket and until the full 85% of your total Social Security benefit has been taxed, if you take an additional $100 out of your IRA you will be taxed on 25% of $185, not $100, which is $46.25, a marginal rate of 46.25% of the actual $100 that you withdrew.

Dividends and Long Term Gains make your marginal tax rates more complex. The taxation of dividends and gains are delayed until your other taxable income plus the gains reach the 25% tax bracket. At that point each $100 of additional income will be taxed at your ordinary income rate, 15%, and it will also cause $100 of your gains to be taxed at 15%. You will be paying 15% of the total $200 or $30 which is a marginal rate of 30%. If you add to that the 85% taxability of your SS benefit you will pay 15% of $370 or $55.50 which is a marginal rate of 55.5% of the actual $100 that you withdrew.

There are 5 different tabs in the spreadsheet provided with the article that allow you to create a customized picture of where your retirement income sources place you along the marginal taxation scale. Each tab has 6 yellow cells that you fill in with your information that will then create your own personal graph.

The Humps are easy to see in each graph, you will also notice the following:


 * The size of The Hump increases as your Social Security Benefit increases.
 * The Hump affects your retirement taxation as your standard of living increases.

A first look
This is a picture of a married couple trying to decide when to retire. They want to retire on a gross income of $110,000, 80% of their pre-retirement combined $137,500 income. They have some company stock which will pay them about $3,000 in annual dividends. They get their estimated benefit from Social Security and calculate how much additional income they will need to achieve their $110,000 goal and enter the numbers in the “Married” tab of the spreadsheet.

They are each only 61 years old and their current plan is to retire at their full retirement ages in about 5 years. They take a guess that the compounded COLA adjustments over the next 5 years will be 10% and add that to the graph input values. The tax brackets, deductions, and income levels are adjusted and a new graph is created.

They are now paying a marginal tax rate of 55.5% on some of their retirement income and start looking for alternatives. What if they work an additional 3 years which will increase their Social Security benefits by 125%? They copy their original input numbers from the “Married” tab to the “Marrieds” tab so they can “see” what will happen and then adjust the values on the second line to represent the 125% increase in the Social Security benefits and parallel decrease in ordinary income.

Note how the original thicker red line has a smaller hump since their SS benefit was lower. All of their taxable and gross income ticks are on top of each other and that tick is slightly inside the full retirement age hump. If they take out any additional cash they will be paying a 46.25% marginal tax rate. If they work the 3 extra years, their SS benefits will be higher which makes their hump wider, but their hump has moved further away from their income ticks giving them room to make some additional withdraws without paying the 46.25% marginal rate.

They have reduced the amount of additional ordinary income which will probably make their 401K savings last longer. The smaller blue and red ticks indicate that their after federal tax income has increased which might allow them to take even less out of their 401K.

This is just one example. Download the spreadsheet to see what your graph looks like!

Why is this Important
What if you have an unexpected expense during retirement and you are in the situation where you are up against The Hump or slightly into it. Maybe your car broke down. Maybe you had a large medical bill. Maybe your friends are going on a cruise and you want to go with them.

If you are far enough away from The Hump it might not matter. If your retirement income is high enough that you are well over The Hump, again it doesn’t matter. But, if you are in the situation listed above, very near to the start of The Hump, its impact can be substantial.

This table shows that if you prepared for unexpected expenses in advance by creating a non-taxable source, you can save 46% or even 82.53% of the cost!

Setup
Before we can talk about how to use the chart, we must first talk about how to set up the chart with the proper taxation data.

The spreadsheet is already set up for the 2015 tax tables, personal exemptions and standard deductions. The yellow background numbers will automatically be transferred to each spreadsheet page to perform the various calculations necessary to create the graphs.

In other tax years you need to update the tax tables from the appropriate IRS sources. You also need to update the personal exemption and standard deduction data. After updating these numbers click on the appropriate check boxes to indicate if you and /or your spouse is over the age of 65 (or blind). The spreadsheet will calculate your appropriate standard deduction and again transfer the yellow background numbers to the spreadsheets.

There is another tab called “Estimate”. This tab will help you calculate a very rough ballpark estimate of what your Social Security benefit will be. It is very rough and we highly recommend that you contact Social Security to find out your real number!

At the top of the estimate page you will find two yellow numbers which are the monthly breakpoints between the 90%, 32%, and 15% Social Security brackets. You can find these numbers in Step 5 of Social Security Administration publication Your Retirement Benefit: How It Is Figured.

The income and retirement percentage values are your own personal preference. The “Factor” numbers are again complicated. The SSA page Early or Late Retirement? will convert your date of birth and the date you want to start benefits into the percentage of your full retirement benefit that you will receive.

The planning process
The spreadsheet is already set up for the 2015 tax rates, so download the spreadsheet, and start substituting your own numbers to begin your own individual planning process.

You can use any of the tabs to personalize the information to your individual situation. We will start our planning process with the Compare tab so we can talk about both single and married individuals from one chart.

On this tab you only fill in the yellow cells with the information for a single individual and the spreadsheet merely doubles those values for the married couple, assuming that both spouses have identical sources for income after retirement.

The red line on the chart is for a single individual who is making $75,000 who is 59 and wants to retire as 64 at 90% of their full retirement benefit with a gross income of $60,000. The blue line is for a married couple each with the same retirement goals.

The first thing to notice with this tab is how a married couple will pay higher taxes earlier and their 85% maximum taxability point is reached before they hit the 25% normal bracket so there is no hump for the married couple. You can also note that shorter blue and red ticks are on top of each other which indicates that there is no real marriage penalty after the single individual has been tax on the full 85% of their benefit. The penalty only occurs when the married couple pays the extra taxes earlier.

Also note how the married couple’s marginal rate drops back to 15%, then jumps to 30% before it settles back to the standard 25% bracket. This is the normal taxation line which is caused when the dividends and long-term gains become taxable and it explains the 55.5% tax hump. 185% of 15% is 27.75% and 185% of 30% is 55.5%.

The single individual will be “over the hump”, they will be paying the 46.25% and 55.5% marginal tax rates on a substantial portion of their taxable income. They have 5 years before retirement. So what can they do to make retirement more affordable?

Adjusting your income sources
The primary thing to do is to adjust your retirement income sources so that an appropriate portion of your gross income required for a comfortable retirement comes from a non-taxable source. Let’s do some adjusting so you can see the advantages of this before we talk about how to make the adjustments.

As we move $4,000 of their income from ordinary taxable income to a non-taxable source, the small blue and red ticks indicate that their taxes are reduced and their after tax income increases, but they are still in The Hump and any unexpected expenses will be taxed at The Hump rates. Since we live on our after-tax income, not our gross income, we can reduce our ordinary income by $6,565 when we increase our non-taxable by $4,000 which pulls us out of The Hump and gives us a little breathing room for unexpected expenses. The graphs allow you to make your own personal adjustments to find out what is best for you.

So, where do you find alternative sources for non-taxable income? Once you are in retirement your income will consist of Social Security, taxable pensions, taxable annuities, and other taxable sources. You might also receive income from non-taxable sources like the sale of personal items, moving to a smaller home, taking out a reverse mortgage, withdrawals from a Roth IRA, and other sources.

There are also hybrid sources of income such as qualified dividends and long-term capital gains which are taxed at different rates and income from municipal bonds which is only used to determine the taxability of your SS benefits, then not taxed by the federal government! The spreadsheet gives you separate cells for reporting these hybrid income sources and the tax calculations take them into consideration.

Proper planning before retirement can help balance these sources so you can maintain your standard of living without paying any taxes in The Hump. A Traditional IRA to ROTH conversion is an excellent way to achieve your retirement goals if you have time to do your planning before retirement.

Roth IRA conversions
A Roth IRA account is an excellent source of non-taxable income during retirement. Your money grows tax free and dollars taken from a Roth during retirement do not cause the taxable portion of your Socials Security to increase. Unfortunately your annual contributions to a Roth account are limited to $5,500 before the age of 50 and $6,500 after the age of 50. One way around these limitations is the Roth conversion. You are allowed to convert Traditional IRA holdings into a Roth IRA account if you pay the taxes on the amount that you convert. If you take your taxes out of the funds you transfer:


 * If your pre-retirement and retirement tax rates are the same the ending after tax dollars are the same, you are just paying your taxes today instead of when you withdraw the money.
 * If you can convert the funds at 25% today to avoid the 27.75% marginal bracket in retirement, 15% at the 85% taxation level, your financial gain will be 2.75%.
 * If you can convert funds at 25% or 28% today to avoid the 46.25% or 55.5% marginal brackets in retirement your financial gains will be substantial.

If you can find an alternate source for paying the taxes it is the same as making an additional contribution to your Roth account.

What if you are already retired and stuck in a situation where you will be over The Hump each year or just for an unexpected expense this year? That also means that you are back to the 25% and then 28% standard tax brackets. You could do a very large conversion of a portion of your Traditional IRA to Roth at those lower brackets so that you could replace a portion of your taxable income with non-taxable income in future years. Just remember that there are penalties involved if you use the converted funds within 5 years of the conversion. Plan ahead! If you need $7,000 a year to feel comfortable then you should do your conversion every time your Roth account gets down to $35,000 so that you have $7,000 a year for 5 years before you need to use the newly converted money.

One special note here, The Hump situation was designed to get more intrusive over time. When the 1983 and 1993 amendments to Social Security were put in place the points at which taxation of your benefits were set to start at $25,000 for an individual and $32,000 for a married couple for the 50% taxation level and $34,000 for an individual and $44,000 for a married couple for the 85% taxation level. The median family income in 1984 was about $22,000 so a starting point of $32,000 did not affect most couples. The problem is that these taxation points never change, they are not COLA or inflation adjusted. The median family income is now over $55,000 so the $32,000 start taxation point now affects a vast majority of married couples. In fact, the $55,000 level is even higher than the $44,000 taxation point for the 85% taxation level!

Since the taxation points are fixed and our incomes will continue to rise with inflation the taxation of our Social Security benefit is only going to increase over time.

Conclusion
The important thing to take from this article is that The Hump exists and it is very important for you to understand your current or eventual retirement income situation as it relates to The Hump. The earlier you start planning to avoid it, the better off you will be in retirement.