Social Security tax impact calculator

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

Overview
Before we get started, according to the old cliché, a picture is worth a thousand words:

Throughout this article we will be referring The Hump and how to avoid it. The Hump is a range of your retirement income where your Federal Marginal Tax Rate jumps 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.

This is an illustration of an individual who earned a COLA (Cost-of-Living Adjustment) adjusted average income of $75,000 who would get about $28,200 in SS benefits and then got an additional $31,800 from other taxable sources to live off of $60,000, 80% of their pretax earnings. The tallest orange tick mark shows that person’s gross income. The red and blue lines above the gross income shows their income tax rate on the last dollar they received from their taxable source.

Setup
Setting up the spreadsheet for yourself if relatively simple. The yellow frames are the ones you have to update. The ones on the right should be updated annually and are currently up to date for 2015. They are used by the spreadsheet to determine your marginal tax bracket and how much tax you will pay at standard deductions.

For example: you pay $923 plus 15% of your earnings over $9225 (line above) until you reach $37,450. To keep things accurate, you should look up these number on line each year.

The SS and IRA boxes are the primary input to the chart. Since the spreadsheet works in $100 increments you should round both entries to the closest $100. The SS number is your annual SS benefit and the IRA number is the amount of your other taxable income. The second number is only used to place tick marks on the chart to show you your situation.

Description
There is a calculator on the right side of the spreadsheet to help you to estimate these values if you are not receiving SS benefits yet. The link at the top take you to the SS estimator where you will find the two yellow monthly numbers in step 5 of their instructions. You then input your average income(s) and the “factor” that will be applied to your full retirement benefit based on the age you plan to retire. You can also enter the percentage of your current gross income that you want to retire on. I used 80% because many of us put 10% of our income into a 401K and pre-tax earnings necessary to pay your FICA taxes is also about 10%.The Hump

This results in the tan-colored SS and IRA numbers, note that the married number are one-half of the total for the couple.

Back to the usefulness of the top illustration. The tick marks from right to left show your gross income, your net income if SS was not taxed, net income for a single person, and per capita net income for a married person. The difference between single and married is due to the pink SS limits, the married limits are less than twice the single limit.

The highest gross income tick is what to use for planning. In this case the single individual is barely avoiding the 46.25% marginal tax bracket, The Hump, and the married couple is almost at the end of their hump. The start of the married hump is about $57,000 and their gross tick is at $60,000, a difference of $3,000 per capita. If they could find an alternative non-taxable source for the $6,000 and reduce their taxable retirement income by that amount, they could avoid The Hump and be in relatively the same situation as the single individual.

But in both cases they should look for additional sources for tax free income in case they have an unexpected expense. Also, the pink Taxable SS Limits are fixed and do not adjust with inflation, so these breakpoints will probably get worse over time.

If you can do it before you start collecting SS benefits, the conversion of some of your Traditional IRA to a Roth IRA is a great way to create non-taxable income during retirement. Note the tax free municipal bond income is used in the calculations using the pink limits whereas Roth in The Hump income is not. Also note that there are penalties that you will pay if you use your Roth converted capital in less than 5 years.

There is another thing that the married couple could do if they do not have a source for non-taxable income. Since they are over the hump, they could convert some of their standard IRA to a Roth IRA at the 25% and maybe 28% brackets. They may have to wait 5 years to use each conversion amount, but it would save the 46.25% later by paying the 25% today. They might also consider using a home equity loan during the first 5 years to avoid the 46.25% marginal tax bracket for a 4% loan interest, then use the Roth money to pay off the loan after 5 years.

Support
Support and on-going discussion is available in this forum thread: [ Spreadsheet to show how the taxable SS benefits will affect you]