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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!

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 46.25%. 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.

Once you see the first example of the graph created by this spreadsheet, you will understand why it was called The Hump.

Let’s look at the following 3 examples of an average Income before retirement, 80% of which should maintain your current standard of living, your expected Social Security benefit if you work to your full retirement age, and the amount you would have to withdrawal from your IRA to achieve the 80% income level.

The Humps are easy to see in all three graphs, 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.
 * The red and blue ticks are almost on top of each other in the $90,000 example because once a single person has paid all of their Hump taxes, the marriage penalty is gone.

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 of 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.

The table (included with the spreadsheet) shows that if you prepared for this unexpected expense in advance by creating a non-taxable source, you can save 46% 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 is 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 the Single or Married tabs to personalize the information to your personal situation. We are using the Compare tab so we can talk about both single and married individuals from one chart. You only fill in the yellow background income boxes for the single individual and the tab merely doubles those values for the married couple, assuming that both spouses have identical sources for income after retirement.

The first example assumes that your average inflation adjusted income over your top 35 years was $75,000 and you want your retirement lifestyle to remain relatively constant so you want a retirement income of $60,000. Fill in your estimated Social Security benefit and a taxable income that will bring your gross income to the desired level.

The “Compare” spread sheet will automatically set the married income levels as if each spouse was earning the same amount and displays the following graph.

Note how the right hand tick mark is green with a small orange top. This is because all of your income is taxable. The position of the orange tick mark makes it easy to see the potential problems for both the single individual and also the married couple.

Note: Your SS entry can be any even dollar amount, but if you want to see the tick marks your taxable and non-taxable income entries must both be in even $100 increments.

The married couple is “over the hump”, they have already paid the 46.25% marginal tax rate on a substantial portion of their taxable income. The single individual is “up against the hump”, they have not paid the 46.25% tax on any of their income at this income level, but if an unexpected expense comes up during retirement, they will be “in the hump”. If you add their state and local taxes to the 46.25% federal marginal tax, their total tax rate will probably be more than 50%. If they need an extra $1,000 to cover an unexpected expense they will need to withdraw about $2,100 from their taxable IRA so they can pay $1,100 in taxes and keep $1,000 for themselves.

This illustrates the primary purpose of the spreadsheet, to let you “see” the relationship between your income and the 46.25% marginal tax rate. So what can they do?

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 before we talk about how to make the adjustments.

As we start finding alternate non-taxable sources for income. At the $3,000 non-taxable level we can see that the orange taxable income tick begin to move away from the green gross income tick which remains stationary. You can also see the white background spreadsheet number change above the chart to show the lower levels of taxation.

The first attempt to find non-taxable income gives the single individual some breathing room as their taxable tick moves away from the 46.25% taxation point, but the married couple needs more.

As we increase the non-taxable portion from $3,000 to $5,000 the situation gets even better for the single individual but the married couple is now “up against the hump” the same way the single individual was in the first example. They will need more work done if they want breathing room.

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-like withdrawals from various accounts where the interest is taxed annually but the principle is not taxed when you withdraw it. Since these income sources can follow a number of different taxation policies, which could even be different for each state, you will have to do your own individual work to convert your hybrid income sources into the taxable and non-taxable amounts handled by this general use spreadsheet. You are welcome to download the spreadsheet and make any modifications needed for your own personal situation.

Proper planning before retirement can help balance these sources so you can maintain your standard of living without paying any taxes in The Hump.

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% marginal bracket 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 married, already retired, and stuck in the $75,000 example as shown above? The green and orange tick marks indicate that you are paying the full Hump taxes. 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.

Singles
The Singles tab is designed to compare and / or combine the unique data input of two single individuals.

The data on this sample page represent two individuals who were both earning $75,000 and want to retire on $60,000. Using the very rough estimates from the Estimate page (get your data from Social Security), one of them retires at 66 getting their full retirement benefit of $27,158 and the other retires at 64 getting 86.67% of their benefit at $23,538.

Note how the 9% and 12% gross income ticks on the right are the same while the 30% taxable income level ticks illustrate how the various SS and taxable income amounts change their taxation points. The red taxable tick is inside the Hump and is responsible for the larger distance between the first two red ticks versus the first two blue ticks.

This data can be used in two ways:

It could be used by one single individual trying to answer the question, what if I retire early or wait till later? This is why the sample data was entered as if both individuals were making the same money and had the same retirement goal.

It could also be used by two single individuals who are sharing living expenses. In this situation the data entries would be customized for each individual and the third “Couple” line would give them their combined budgeting estimates.

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.