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.
This article or section is in the process of an expansion or major restructuring. You are welcome to assist in its construction by editing it as well.
Contributor note: The spreadsheet dedicated to SS tax impact (TheHump.xlsx) has not been updated for the 2018 tax law changes.
Instead, the Personal finance toolbox spreadsheet can graph the tax impact of SS benefits, and includes 2018 tax law changes.
Download the latest spreadsheet from Google Drive:
- Click on: TheHump.xlsx.
- Hover your mouse near the top of the page and click on the icon to download the file. (Ignore the error message about loading pages.)
Support and on-going discussion is available in this forum thread: Spreadsheet to show how the taxable SS benefits will affect you
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 blue line illustrate the taxes paid when all of your income comes from ordinary sources. The red 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 of 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
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.
Let’s look at these parallel taxes from a spreadsheet point of view.
In the Green taxation lane you pay your normal federal tax rates on the additional income that you receive.
In the Gold lane you first get your Social Security benefits as tax free income, then the 1983 and 1993 amendments to the Social Security act kick in so the additional income also makes a portion of your previously tax free Social Security benefit taxable and you pay your normal federal tax rates on the now taxable portion of your benefit in parallel to the taxes paid on the actual income you received.
In the Purple lane, as with your Social Security benefits, you initially get your Long Term Gains tax free, then as you approach the top of your 15% bracket the combined amount of your actual income plus the taxable Social Security pushes a portion of your long term gains into the 25% bracket where they are then taxed at a reduced rate of 15%.
The ratio between the actual total income and the total taxes paid in all three parallel tax lanes is what creates your Marginal Tax Rates.
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.[note 1] 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 (NRA). You can then use the Social Security Early or Late Retirement page to calculate the percentage of your benefit that you will get based on the month and year you plan to retire. Use the table at the bottom of this page to calculate and save your benefit amounts for your various “What If” scenarios.
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 personalized 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.
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 than 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.
Looking at the previous graphs you can see that the increases in your social security benefits push the start taxation points for those benefits to a higher dollar value while the gross income tick mark moves up faster because the start taxation point is a fixed value while the gross income is adjusted for inflation. The [Historical] tab on the spreadsheet gives you a more detailed example of how this happens.
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, 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.
And if you can pay the tax out of non-retirement accounts, the conversion would be more advantageous.
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.
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.