User:PapaGeek/Sandbox

 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.

Marginal tax rates
According to Investopedia: Your Marginal Tax Rate is “The amount of tax paid on an additional dollar of income.”

Prior to retirement we are all familiar with the 10%, 15%, 25%, etc. tax rates that created the blue line in the first graph.

We initially receive our Social Security and Long Term Capital Gains as tax free income and this is what pushed the initial taxation point of the red line well past the blue line. The problem is that these income sources are not actually tax free, their taxation is merely delayed until your gross income sources reach higher levels and inflation is causing retirees to reach those higher levels earlier each year.

Once you start paying these delayed taxes, you pay them in parallel to your standard income tax rates which is what creates the higher marginal income tax rates.

The dotted green line in this second graph represents the 50% and 85% “taxability” levels of your Social Security benefits as defined by the 1983 and 1993 amendments to the original Social Security Act. At the 50% level each dollar of additional income increases your taxable income by $1.50 and the 85% level increases your taxable income by $1.85. This explains why most of the solid red marginal tax rate line is 50% higher then 85% higher than the dotted red standard IRS tax brackets. The 55.5% Marginal Rate is created by the combination of the delayed taxation of your Long Term Gains, the dotted blue line, compounded by the 85% taxability of your Social Security benefits, you are basically paying parallel taxes on your parallel taxes. The shape of the 55.5% and 46.25% Marginal Tax Brackets in this chart is why the spreadsheet is called The Hump.

Setup
The spreadsheet is already set up for the 2015 tax tables, personal exemptions and standard deductions. The yellow background numbers from the [setup] tab 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 [PIA]. Before using this tab you should contact Social Security to get your personal PIA (Primary Insurance Amount) for your normal retirement age. You can then use the Social Security page page Early or Late Retirement to calculate the percentage of your benefit that you will get based on the month and year you plan to retire. Then just plug in these two number to calculate your annual Social Security benefit for the graphical tabs of the spreadsheet.

You can then use the [Incomes] tab to itemize and sum up the remaining 5 income fields you will need.

Once all of this information is available you are ready to start creating your personal Marginal Tax Rate graphs and What If tax savings charts.

A first look
After you download the spreadsheet you can fill in your own private income information to create a graph of what your personal marginal tax brackets will be. Just choose the [Single] or [Married] tab based on your filing status.

You only have to fill in the 6 yellow cells in the upper left corner of the spreadsheet to create a chart based on your retirement tax situation. The shape of the red line will be determined by your personal Social Security Benefits and your Long Term Gain income. The orange tick mark will show you the relationship between your gross taxable income level and your marginal tax rates. The numbers used on this graph were chosen specifically to represent an upper middle class individual whose gross income of $63,000 places them just at the start of The Hump marginal tax rates.

The COLA cell is a very important feature of the spreadsheet. It allows you to estimate your potential tax situation as the cost of living changes. The actual marginal rates are not based on the values you entered at the top of the graph, they are based on the values at the bottom of the graph that have been adjusted by the COLA rate. The tax brackets, exemptions and standard deductions are also modified by the same COLA value. COLA was originally designed to allow you to look a few years into the future, but negative values also allow you to look into the past and this can reveal a something very important, your personal tax situation will most likely get worse with inflation.

Historical Impact
The COLA entry was designed to let you look into the future to see what will happen when the cost of living goes up, but it can also be used to give rough estimates of historical representations of the system. The Social Security Administration publishes a list of yearly Index Factors that can be used to convert historical dollars into today’s dollars. The index factor for 1983, the year that the first Social Security taxability amendment was passed, is 3.05. Using this Index Factor in reverse, a COLA factor of -67% can be used to change today’s dollars into 1983 dollars. Note how the orange income values are now 33% of today’s incomes. Also note that the adjusted orange Upper Middle Class gross income tick mark in 1983 is considerably less that the start of the 50% taxation point created in 1983 which is represented by the dotted green line. Ten years later when the 85% taxation bracket was added by the 1993 amendment the index factor was now 2.01, an inflationary increase of about 33% over the 1983 value, but since the $25,000 taxability point for the 50% level did not change, an Upper Middle Class income was now close to making a portion of your Social Security benefit taxable. World War II ended in Europe on May 8, 1945 which caused the baby boom generation to start in 1946. Those born in 1946 reached their early Social Security retirement age of 62 in 2008. The index factor for 2008 was 1.12 making the COLA adjustment about -10%. The base $63,000 Middle Class Income we are using is now well into the 85% taxability bracket and nearly into the hump. Using the COLA factor for its original intent, looking into the future, we see that the base Upper Middle Class income has now moved into the hump area. Basically we have to plan to avoid the hump area by a reasonable margin so that inflation does not push us up against its proverbial brick wall for our standard of living during retirement.

What if
The spreadsheet also contains a pair of “What If” tabs, [Singles] and [Marrieds], which allow you to enter two sets of income values so you can compare the results. This is a married couple who wants to have a $100,000 after tax income during retirement. Their current situation, the dark red line with the tallest orange tick mark, indicates they will be right at the start of their “Tax Hump”. Their second option is to work part time and delay taking their Social Security benefits for two additional years. This situation is represented by the lighter orange line and the tall red tick mark. If they wait they will get more tax delayed income which will allow them to take more than $10,000 less out of their 401K accounts each year while staying a reasonable distance away from their new Tax Hump.

Note that their tax hump is bigger because their Social Security is higher but the higher Social Security also pushed the start of their Tax Hump further down their gross income stream. Note also that their effective tax rate is considerably lower. A special note here: The [Singles] tab has a third line above the graph that is the sum of the two yellow lines. This is designed so the tab can be used to compare the What If situation for a single individual and also used by a non-married couple who is planning to share expenses during retirement.

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, you 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.

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.