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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.

Disclaimer
This page was created using the 2016 tax brackets. The author is not a qualified tax accountant or investment advisor, so use this information at your own risk!

Tax Brackets
Let’s start this discussion with the old cliché: A picture is worth a thousand words.



The blue line in this picture represents the normal tax brackets that you currently face during your working years. It has been enhanced with a small amount of Long Term Capital Gains or Qualified Dividends to show how this class of income changes the normal tax brackets. This income is initially tax deferred, then when it is pushed into the normal 25% brackets it is taxed at 15% at the same time as the income that pushed it into that bracket is also taxed at 15%. This double taxation results in a 30% marginal tax rate before the 25% bracket starts.

It is important to understand this double taxation concept before looking at the green line that represents the marginal tax brackets that you will face while receiving your Social Security Benefits. Your benefits are also tax deferred. The dotted red line shows where your benefits become 50% taxable and then 85% taxable. The dotted green line shows the normal federal brackets.

Note that the first retirement marginal tax bracket is 15%. You are already in the 50% Social Security taxability bracket when the normal 10% bracket starts so you are paying 10% of each dollar of taxable income plus 10% of the 50 cents of Social Security that that dollar made taxable. You are again being double taxed on the new dollar of income plus the deferred Social Security benefit that that dollar made taxable.

There is a section of green line at the 27.75% marginal bracket which is 185% of the normal 15% tax bracket. The small 55.5% marginal bracket is actually double taxation of your double taxation. It is 15% on the actual dollars earned plus 15% on your gains and dividend, and all of that times 185% due to the taxable Social Security level. The 46.25% marginal bracket is 185% of the normal 25% tax bracket which ends when 85% of your total Social Security benefit has been taxed. At that point the double taxation stops and you go back to the standard 25% tax bracket.

Median Viewpoint
When your Social Security Benefits and other taxable income places you in section A of this graph you are primarily looking for ways to avoid paying any taxes. When you are in section D you are looking in the rear view mirror at the fact that 15% of your Social Security Benefits were tax free and you paid a lower rate on your capital gains and dividends.

This page is designed to look at sections B and C of the graph. These sections are generally faced by those earning slightly above the current median income level of $50,000 but not yet into the six figure category, this represents a fairly substantial percentage of the population. What can you do to avoid paying the 55.5% and 46.25% marginal tax bracket?

So, let’s take a look at some taxation examples:



These graphs illustrate a few very important points:
 * 1) Look at the “Tax Rate” columns: The taxability of your Social Security benefits occurs earlier for married couples which creates a marriage penalty for median income individuals.
 * 2) All of the marginal tax bracket lines are different: Your personal graph probably does not look the same as anyone you know.
 * 3) As your Social Security benefit increases:
 * 4) *The income where you start paying taxes increases, you save more tax dollars.
 * 5) *The size of your personal 46.25% tax hump increases, the IRS wants more back.
 * 6) The colors of the required gross income tick marks for the same after tax standard of living is in the reverse order from the start taxation lines. You are replacing less tax deferred income with taxable income.

Standard of Living


These are average SS Benefit graphs based on earning an inflation adjusted average income of $60,000 when you retire at 62, 66, and 70. The tick marks in the left graph illustrate your gross income when you plan your retirement at 80% of your pre-retirement income and the right graph illustrates 90%.

Note how increasing your standard of living requires more ordinary (taxable) income which increases your tax rate. Also note that the tick marks at 80% are all below their related 46.25% marginal tax rates while the green tick is beyond that rate and the blue tick is barely starting the 46.25% rate when living on 90%.

Inflation


Using today’s retirement income of $30,000 SSB plus $27,000 from taxable sources line IRA/401K withdrawals, pensions, annuities, etc. plus $6,000 of capital gains, we can adjust those income by the inflation factors for 1983 when the 50% taxability bracket was created, 1993 when the 85% taxability bracket was create, today, and what it will look like when a compound 25% COLA increase occurs.

The taxability points were set in 1983 and 1993 at $25,000 and $34,000 for single individuals and $32,000 and $44,000 for married couples. These taxability points are not COLA adjusted so they are the same now as they were 23 and 33 years ago. As a result inflation is making larger percentages of our benefits taxable each year which pushes us into higher marginal tax bracket.

But, if you do see a potential problem, what can you do?

Pay off Mortgage
We saw an example of what happens when we increase our income to increase our standard of living. What if we could reduce our income by eliminating our mortgage payment?

If your personal situation makes this profitable, instead of putting extra money in your 401K saving your current 25% tax bracket and later withdrawing that money at 46.25% to make a mortgage payment, put that extra money into a Roth account after paying the 25% tax so you can withdraw it at 0% later to pay the mortgage.

Roth Conversions
Instead of contributing $6,500 to your Roth account, what is you used that money to pay the taxes for a Roth Conversion? You could move/convert $21,225 of your standard IRA to Roth which, depending on your State, would cause a 7.5% state tax of $1,592 which would be deductible making your federal taxable income $19,633 and result in a federal tax of $4,908. In other words, your $6,500 Roth “contribution” could be enough to cover a full year of mortgage payments.

There are many things that you should consider when thinking about a Roth Conversion. Paying 25% federal tax while working does save you a small amount over paying a 27.75% marginal rate while retired, but not if you are now working in a high tax state and retire in a low tax state. Paying 25% or 28% now to avoid 46.25% later is probably a good idea even if you do move to a low tax state.

Medicare Part B
Beware of the hidden “taxes” if you decide to do Roth Conversions after starting your Social Security and Medicare benefits. Your 2016 taxes will be processed in 2017. Your MAGI, Modified Adjusted Gross Income (see Medicare site for the modifications), will then be used to determine your Medicare Part B rates for 2018.

Here are the Part B premiums for 2016. Note that if your MAGI goes over $85,000 your annual Part B cost will increase by $584.40 and if it crosses $107,000 it will increase another $877.20.


 * [[File:Part_B.jpg]]

Cost of money
What if your friends come to you with the idea of taking a cruise together each winter? You will need an extra $6,000 of after tax money, how will you get it? Your current retirement situation puts you right up against your personal tax hump. The Cost Of money column lets you know that the cost of $6,000 of after tax spendable money will be $11,427 at a marginal tax bracket of 47.49%. The small red tick marks also let you know that you will be over the hump and back in the 25% tax bracket after paying for just one cruise. A second cruise will now only cost you $8,000 at the 25% bracket.

If you do not have a picture of what is happening you will probably not withhold enough taxes and have a huge tax bill the following April, after all, your effective tax rate so far has only been 6.8%. Without the picture why would it be 47.49% now? You might also do the proper calculation for this year only and start paying $11,427 each year for each cruise. If you do have this picture you can see that additional cruises will only cost $8,000, a $3,427 savings for each additional year.

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.

The marriage penalty
The 1983 Social Security Amendment set the start of the 50% taxability of your benefits at $25,000 for a single individual and $32,000 for a married couple.

The 1993 Social Security Amendment set the start of the 85% taxability of your benefits at $34,000 for a single individual and $44,000 for a married couple.

Since the married couple’s start points are less than double the single individual’s start points their combined Social Security Benefits become taxable earlier. In the long run they will not pay more tax, but they do pay their taxes earlier which is a penalty to them at certain income levels.

The [Compare] tab of the spreadsheet allows you to enter the income levels for a single individual. It will then double those amount for the married couple and plot both marginal tax lines on a per capita scale.

Adjusting your income sources
If the married couple in the previous example was not aware of their choices they would just continue to pay an extra $5,090 more in taxes each year than their single friends living next door sharing retirement expenses. If they knew about this situation before retirement they could have planned to move some of their retirement income to non-taxable sources like a ROTH account.

In this example they were able to find a $7,500 annual source of non-taxable income which allowed them to reduce their traditional IRA withdraws by $13,750 and reduce their taxes by $6,249 while keeping their after tax income constant.

The creation of $7,500 would have cost them $10,000 at the 25% level and $10,417 at the 28% level prior to retirement. This is a huge improvement over the $13,750 cost during retirement for the same after tax income level.

Just remember that you have a 5 year waiting period before you can withdraw newly converted ROTH funds without paying a penalty.

Keeping in mind that this article is not being written by a financial advisor or tax accountant, there many other ways to create relatively tax free income during retirement. You might be able to take a portion of your pension as a lump sum. You might consider a reverse mortgage.

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.