Disclaimer

I am not a qualified Investment Advisor or Tax Accountant or CPA. I am totally unqualified to give you any of this advice. So, use the informaiton in this presentation at your own risk!
The problem here is that no one else will give you this information.

If you ask your broker or investment advisor about the marginal tax rates you pay while receiving Social Security, they will tell you to talk to your tax accountant. They can literally lose their brokers license if they give you tax advice!

Your tax accountant at H&R Block or other storefront tax services rarely have any idea which are the best investment strategies to use or which stocks, bonds, or funds to invest in.

A CPA can give you this advice, but lets be honest, is it worth their time and effort to help you save 2 or 3 thousand dollars a year, how much are you willing to pay for that service? I talked to the investment guy at my bank and that is exactly what he told me.


If you are a middle or upper middle class individual who earned 50 to 100 thousand a year and like the idea of adding a couple thousand to your yearly standard of living during retirement, use the ▶ right arrow key on your keyboard to view this demonstration. If you like what you see, come back to this page and use the ▼ down arrow key to see the page where you download your own copy of your personal marginal tax rates spreadsheet, verify that data with your tax person, and then talk to your investment advisor about how to manage your money.

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Excel Spreadsheet

You can download the spreadsheet used to create the slides for this presentation from the google drive. Use this link to bring up TheHump.xlsx and then use the down arrow on that page to create your own personal copy of the spreadsheet on your personal disk. This way you will not have to enter your personal data on line, it stays on your personal computer.


Wiki Page

This entire project started with a forum thread on the BogleHeads.org forum which then lead to the publication of a BogleHeads Wiki page that was used to explain the spreadsheet’s usage in more detail. The Wiki page also contains a link to download the spreadsheet.


Sorry that the URL links above are grey within black text. I'm using publicly available web presentation software and I’m not yet capable of modifying the display styles!






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What is the purpose of this demonstration? You are retired now and life is great. You have managed to substitute the time spent in the office by doing things with other retirees and discussing how you ever had time for all that office stuff.

As the fall chill hits, the group starts talking about the possibility of taking a
winter cruise together. This sounds like a great idea and you estimate that the cruise will cost about $8,000. Based on previous tax years, you estimate your tax rate at about 30% so you take $12,000 out of your IRA and withhold $3,600 to
cover the taxes. You end up with $8,400, more than enough to cover the cruise.

Just to be sure, you have your taxes done before you leave for the cruise and discover that you still owe about $1,200. Instead of having an extra $400 in
spending money on the cruise, you now have to cut your fun back by $800.

This demonstration is designed to give you a picture of your personal marginal tax rates
so you can accurately plan for things instead of guessing.

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Don't just guess!

If you had this picture of your personal marginal tax rates and knew that your current standard of living, the orange tick mark, placed you close to your personal 46.25% marginal tax bracket, you could play with the numbers on the chart to see that you would need to withdraw $13,427 at the 27.75% then 46.25% tax brackets to obtain the $8,000 you need for the cruise, not $12,000. Better yet, if you could see this graph a couple years before retirement, you could take the proper steps to avoid the 46.25% marginal tax bracket completely!

The old cliché says that a picture is worth a thousand words, but in this case, a picture is probably worth thousands of dollars!

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Normal Tax Brackets

Everyone is familiar with the green line, the normal 10%, 15%, 25%, etc. tax brackets that we pay during our working years. The blue line represents our tax brackets when we also have long term capital gain or dividend income. The gains are initially given to us tax free and then at a certain income level they are slowly tax at a reduced rate in parallel to the taxation of our normal income. We will see a lot more about "parallel taxation" as this demonstration continues.

Use your keyboard arrows to move through this Reveal.js presentation. The compass in the lower right hand corner will let you know what slides are available. On this slide the down arrow ▼ will allow you to change the theme, the font and color scheme of the slides. On other slides the down arrow will be used when a look back at a previous slide might be useful.



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Themes

reveal.js comes with a few built in themes.
If you are displaying this with a projector on a wall,
click on the various themes to see which is
more readable for your audience.

Black (default) - White - League - Sky - Beige - Simple
Serif - Blood - Night - Moon - Solarized

Use your up arrow to return to the first slide.


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Marginal tax brackets during retirement

The Marginal tax brackets we face during retirement are extremely different than the federal tax brackets we are familiar with during our working life. Understanding the differences can literally save you thousands of tax dollars every year - if you do the proper retirement planning.

Everyone’s marginal brackets are different, there are no fixed dollar amounts. This presentation is designed to explain how your personal brackets are created and lets you see where your gross income places you within those brackets so you can do the proper planning to avoid the excessively high brackets during your retirement.





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Taxes During Retirement


Taxes during retirement are far more complex than they were while you were working.
They are both your friend and your enemy.

We are all familiar with the normal 10%, 15%, 25%, etc. Federal Tax Brackets that are represented by the red lines on this chart.

The Orange Line represents the marginal tax brackets we face during retirement. Our Social Security Benefits are initially given to us tax free, they are then taxed in parallel to our normal income as our income increases. When Long Term Gains are included, this parallel taxation can cause marginal tax rates as high as 55.5%.

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You can save thousands in taxes at lower incomes

  • With a $30,000 Social Security benefit and $6,000 in long term gains, taxation does not start until your gross income has reached over $45,500 at which point you have saved $4,546 in taxes.






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Keep the savings as you start paying taxes

  • With a $30,000 Social Security benefit and $6,000 in long term gains, taxation does not start until your gross income has reached over $45,500 at which point you have saved $4,546 in taxes.
  • Over the next $17,500 your marginal tax rate is only slightly higher than normal taxes so you slowly give $251 of those initial savings back to the IRS.




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The Hump - rapidly give most of the tax savings back!

  • With a $30,000 Social Security benefit and $6,000 in long term gains, taxation does not start until your gross income has reached over $45,500 at which point you have saved $4,546 in taxes.
  • Over the next $17,500 your marginal tax rate is only slightly higher than normal taxes so you slowly give $251 back to the IRS.
  • What we want to avoid is "The Hump"! Over the next $11,000 your marginal tax rates are 55.5% and 46.25% causing you to quickly give back an additional $2,570.



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You gave thousands back, but you still save a little!

  • With a $30,000 Social Security benefit and $6,000 in long term gains, taxation does not start until your gross income has reached over $45,500 at which point you have saved $4,546 in taxes.
  • Over the next $17,500 your marginal tax rate is only slightly higher than normal taxes so you slowly give $251 back to the IRS.
  • What we want to avoid is "The Hump"! Over the next $11,000 your marginal tax rates are 55.5% and 46.25% causing you to quickly give back an additional $2,570.
  • These excessively high marginal tax rates stop after 85% of your benefit has been taxed. Your total tax savings is now only $1,725 which is 15% of your $30,000 Social Security benefit taxed at the 25% federal bracket plus your capital gains were taxed at 15% not 25%.

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The Hump

Is my Hump the same as your Hump?

No

The size and position of your personal Hump is defined by the size of your personal Social Security Benefit.
There are literally tens of thousands of different Hump shapes, which is why you need some sort of spreadsheet or program to tell you what your personal hump looks like!



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15K

At the $15,000 Social Security level the tax hump does not even exist.
The 85% taxability of your benefits ends before the 25% federal bracket starts.
Also note that because the 10% federal bracket now starts before 50% taxability begins,
you also have a small window where your marginal tax rate starts at 10%.


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20K

Benefit Start Tax Save Start Hump Width Return
$20,000 $35,567 $3,096     $55,243 $3,460 $1,946
At the $20,000 Social Security level The Hump does exist because the 25% federal bracket starts,
in this example for the taxability of capital gains, before the end of 85% taxability
and the 10% marginal bracket does not exist because 50% taxability starts
before the 10% federal bracket.
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25K

Benefit Start Tax Save Start Hump Width Return
$20,000 $35,567 $3,096     $55,243 $3,460 $1,946
$25,000 $39,733 $3,721     $59,095 $7,111 $2,383

Higher Social Security Benefits save more tax dollars which creates a larger hump
to pay the savings back, but the hump also starts at higher income levels.

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30K

Benefit Start Tax Save Start Hump Width Return
$20,000 $35,567 $3,096     $55,243 $3,460 $1,946
$25,000 $39,733 $3,721     $59,095 $7,111 $2,383
$30,000 $43,900 $4,368     $62,946 $10,760 $2,843


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35K


Benefit Start Tax Save Start Hump Width Return
$20,000 $35,567 $3,096     $55,243 $3,460 $1,946
$25,000 $39,733 $3,721     $59,095 $7,111 $2,383
$30,000 $43,900 $4,368     $62,946 $10,760 $2,843
$35,000 $48,067 $5,332     $66,797 $14,409 $3,620

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Benefit levels depend on both income and retirement age

The size and location of your personal hump is totally dependent on the size of your Social Security benefit. Your benefit is based on the age at which you retire and the average of the highest 35 years of your inflation adjusted income. Call Social Security to get your Full Retirement Age Benefit, then use the link: https://www.ssa.gov/oact/quickcalc/early_late.html to find out what percentage of that benefit you will get based on the age you plan to retire.

Note that an individual earning $40,000 who waits until age 70 will get a higher benefit
than a person earning $110,000 who starts their bnefits at age 62.

Use the ▼ down arrow on your keyboard to look at some examples.

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This image represents someone earning $60,000 who wants to retire on 80% of their income, $48,000 after tax. The data at the top of the screen illustrates the results of retiring at 62, 64, 66, 68, or 70. To make the graph easier to see, the graph only shows ages 62, 66, and 70.

The solid Marginal Tax Rate lines indicate how larger Social Security benefits result in longer delays before the start of taxation while the parallel color coordinated gross income ticks illustrate that the more tax deferred Social Security you receive, the less gross income you need to achieve the same standard of living at a lower effective tax rate.

Note also that the lowest benefit, retire at age 62, green gross income tic mark
is very close to the start of the tax hump on the green Marginal Tax Rate line.

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At the $70,000 income level your 80% retirement standard of living goal is now $56,000. This causes all of the solid Marginal Tax Rate lines and the coordinated gross income ticks to move to higher income levels.

Note that the green income tic is now after its coordinated tax hump, the blue tic is inside of its tax hump, and the red tic still has additional income available before paying its hump tax rates.

Bottom Line: The longer you wait to retire, the less additional income you will need, the longer your savings will last, and you will be able to enjoy your desired lifestyle for many more years.


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What if $10,000 of your $56,000 After Tax target income was to cover the principal and interest portion of your monthly mortgage payments? If there was no mortgage, you could reduce that target to $46,000 and still live your desired lifestyle!

The $56,000 still shown on this graph as smaller dotted tick marks while your new $46,000 After Tax gross income ticks have moved considerably to the left, to lower income levels. The retire at 70 tick mark now shows that you total yearly tax liability is only $135!

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Retirement Age Trends


Almost 53% of all retirees started their benefits at age 62 in 2004
while less than 25% waited until their full retirement age.
The Social Security Administration’s latest statistical report indicates that
the trend toward early retirement is beginning to reverse itself.
In 2014 nearly 40% of retirees waited until at least their full retirement age
compared to only 37% who retired at age 62.

▼Use your down arrow to see the details on how taxes interact with your SS benefits.▼


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Free Annuity Dinners


When you go to one of those “free dinners”, the guy who is trying to sell you an annuity will tell you that it will take almost 10 years to catch up on your total SS benefits if you wait until 70 to retire. Annuities are a good thing, but the numbers given to you do not include the taxes paid.

Using the tax data from the 70K with and without paying off your mortgage numbers from the previous chart's down arrow details: The first section above shows that they are correct when no taxes are considered, you don't catch up until 9 years and 8 months. The second section shows that you will catch up in only 3 years and 8.4 months if your after tax income / lifestyle is $56,000. The third section shows that you catch up in 6 years and less than 1 month if you pay off your mortgage and lower your necessary after tax income to $46,000.

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Marginal Tax Rates

  • Investopedia defines Marginal Tax Rates as "The amount of tax paid on an additional dollar of income".
  • The delayed taxation of our Social Security benefits and long term capital gains results in marginal tax brackets as high as 55.5% and 46.25%.
  • These ultra high marginal rates are created when the same dollar of income creates multiple channels of parallel taxation.
    • The dollar itself is taxed.
    • The dollar makes 85 cents of your Social Security benefit taxable.
    • The dollar plus the 85 cents of now taxable Social Security makes $1.85 of your
      Long Term Gains and Qualified Dividends taxable.
  • Option 1: If we know the income levels where these high brackets occur, we can try to take steps to avoid them.
  • Option 2: Ignore the Marginal Tax Rates and just pay thousands of dollars of extra taxes each year.



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Marginal Tax Rates

Marginal Tax Rates

Marginal Tax Rates

Marginal Tax Rates

The 55.5% marginal rate is not a bad thing!


The blue marginal tax line starts $6,000 later than the red marginal tax line because your
Long Term Gains are tax free until they are pushed into the 25% standard bracket.

Your tax savings, the total area of the two gaps between the $44,000 and $56,000,
is far less then the amount of tax you must give back,
the 44.25% vs 55.5% gap between the $66,000 and $72,000.



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Should you pay off your Mortgage before starting your Social Security benefits?

If your annual mortgage payment will push you into the 46.25% marginal bracket, definately yes!



Use the down arrow ▼ key to view the details.

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Should you pay off your Mortgage before starting your Social Security benefits?


The first section shows the cost of making mortgage payments before retirement and moving the mortgage payment into your Roth account.

There is no real tax savings if you are past your 46.25% marginal rate, but if your mortgage payments are going to push you into the 55.5% and 46.25% your savings could be substantial.
At 46.25% with deductible interest you will save $502 for each $1,000.
If $8,000 of your annual $15,000 mortgage payment falls in the 46.25% marginal tax bracket,
your annual savings will be over $4,000.

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Inflation is only making things worse

Social Security started in 1935 and the benefits were expressly excluded from federal income taxation under Treasury Department Tax Rulings. This all changed with the 1983 amendments to the Social Security Act. A typically complex government formula was created to define the basis for the taxability of your benefits.
Beginning in 1983 if your basis income exceeded $25,000 for an
individual or $32,000 for a married couple filing jointly up to 50% of
your SS benefit was subject to your marginal tax rate.
So for the first time in history SS benefits became subject to taxes.

The 1993 Omnibus Budget Reconciliation Act (the OBRA) contained
a provision that altered this rule and created a second threshold that
would subject up to 85% of your SS benefit to taxation if your basis income exceeds $34,000 for an individual or $44,000 for a married couple filing jointly.

One thing to note is that these thresholds are not indexed for inflation. They are still the same amounts as when they started in 1983 and 1993. This has the effect of capturing more and more people within the taxation net each year. In 1983 less than 10% of all benefit recipients were subjected to taxes on benefits, but currently that number is over 30% and will continue to rise.



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Today

In 2015 when your Social Security benefit is $30,000, the $63,000 income level puts you at the start of “The Hump” where your marginal tax rates will be 55.5% and then 46.25%.
Let's use these levels to look backward and forward in time to see how inflation is changing your relationship to The Hump marginal tax rates.

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1983

The published inflation factor for 1983 when the first Social Security taxation amendment was passed is currently 3.05. Using a -67% COLA to reduce todays income levels and tax brackets to 1983 levels gives us this chart. The chart indicates that back in 1983 the $25,000 start 50% Social Security taxation for individuals and $32,000 for a married couple would only “tax the rich”.

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1993

The inflation factor for 1993 when the second taxation amendment increased the taxability level to 85% is currently 2.01. The 50% and 85% start taxation points are fixed, they are not COLA adjusted. Adding 10 years of inflation to the previous chart now places the start of taxation just above today's $63,000 Upper Middle Class income level that we are using as an example.

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Today

The $63,000 income level in 2015 puts you past the 50% taxability level and well into the 85% taxability level. You are at the start of “The Hump” where your marginal tax rates will be 55.5% and then 46.25%.


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2025


As inflation moves the tax brackets higher, the start of The Hump moves to the right. Since the end of the 85% taxability line moves slower, The Hump gets smaller, but your income also increased so you are now paying The Hump taxes. The standard deductions and exemptions have also increased, causing the start of each marginal tax bracket to move to higher levels.
It is important to understand this when you are doing your retirement planning.

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The Marriage Penalty

Because $32,000 and $44,000 are less than double $25,000 and $34,000 a married couple will pay more taxes earlier than 2 single individuals sharing expenses during retirement.
The penalty no longer exists once 85% of everyone’s benefits have become taxable. In the end a married couple does not pay more tax, they just pay back their savings earlier.

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The Marriage Penalty


Green Line: The married couple starts paying taxes earlier, their tax savings is therefore
smaller so the size of their Hump to pay back the taxes is also smaller and starts earlier.
The effective tax rate for the married couple is 10.84% vs 6.8% for the single individuals.
The married vs singles couple income after tax is $112,338 vs $117,429, $5,091 less.



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The Marriage Penalty


Blue Line: Once the income levels have reached a point where the single individuals have paid back their full hump taxes, the marriage penalty is all but gone. After tax income is $129,438 vs $129,588, where the $150 difference is caused by the second marriage penalty, the standard deduction for a single individual over the age of 65 is increased by $1,550 but is only increased by $1,250 for married individuals, and 25% of the $300 difference is $75 for each person.
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The Marriage Penalty


The single couple also has another advantage, flexibility. By alternating one individual staying below the Hump while the other makes up the after tax difference at the 25% bracket after paying the full Hump, they can reach the same total after tax income while taking $3,380 less out of their IRAs each year.

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Should you care about this?

    No
    If you are planning to retire at age 62 your personal tax Hump will be small if it even exists!
    No
    If your income is well into the 6 figure range your retirement income will probably be well over The Hump and you will merely look back and say that 15% of your Social Security benefits were tax free.
    Yes
    If your income is Upper Middle Class, $60,000 to $100,000, and you plan to work until your full retirement age or later, your retirement income could easily put you in close proximity to The Hump and you should seriously consider planning in advance on how to avoid it.



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Benefits levels depend on both income and retirement age

Benefit Start Tax Save Start Hump Width Return
$20,000 $35,567 $3,096     $55,243 $3,460 $1,946
$25,000 $39,733 $3,721     $59,095 $7,111 $2,383
$30,000 $43,900 $4,368     $62,946 $10,760 $2,843
$35,000 $48,067 $5,332     $66,797 $14,409 $3,620


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20K

The 20K hump, just over $70,000 at age 62,
has a very small hump.



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15K

The 15K hump, at about $45,000 at age 62,
the hump does not even exist.



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Before we get started on the planning process I have to repeat my disclaimer! I am in no way qualified to give tax or investment advice. Use anything you see in this presentation at your own risk.

The sad part is that if you talk to your broker or investment advisor about how to avoid high taxes, they will tell you to talk to your tax accountant about taxes. If you talk to your tax accountant, some CPAs might be able to tell you things that you might want to invest in, but are rarely as qualified to recommend one stock over another.




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What if you retire at 66?

For our examples, let’s consider an Upper Middle Class couple, both earning about $70,000 who are making plans to retire on 80% of their current earnings. This is a reasonable amount since they are putting about 10% pre-tax into social security and Medicare deductions plus another 10% into their 401Ks.

If they retire at 66 they will be be paying about half of their hump taxes and they know from the previous slides that inflation will only increase that amount.


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What if they work for 2 more years?

If they decide to work for two additional years they will shift $8,000 of their planned income from IRA withdraws to Social Security benefits and they can avoid The Hump. This also lowers their taxes by more than $2,000 a year.




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What if they want to take a vacation?

Their friends ask them to go on a cruise? It will cost them about $8,000 of after tax income. They don’t have this chart and feel comfortable with guessing that their tax rate will be about 30%. They take an additional $12,000 out of their IRA, do an estimate tax payment of $3,600, leaving them with $8,400 for the cruise with an extra $400 of spending money.

Before they leave on the cruise they have their taxes done and find out that they owe an additional $1,180 to the IRS, there goes the extra spending money, plus some!



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Don't just guess at the cost

If they did have a proper way of calculating their taxes due, they would know that they will need to withdraw an extra $13,427 from their IRAs to pay $5,427 in taxes at a combined marginal rate of 40.42%, some at 27.75% and the rest at 46.25%. The SWAG was only $3,600 at 30%.

If they have the graph and can see the actual situation, they could plan ahead and withdraw another $11,077 for a second cruise at a combined marginal rate of only 27.78% and even more at $10,667 after they are completely over the hump and back in the 25% bracket!



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What if they spread out the payments?

If they planned the February trip in November, they could take out an additional $4,000, pre-hump, $2,890 after tax in year 1, then take out what is necessary for the other $5,110 in January. They would be $2,220 short for their normal year in December of the second year so they could take out a 6% loan for 30 days and pay only $11 in interest on it when they pay it back the following January. The result is that they would only pay about $11,100 for the trip instead of $13,427. This can only be done if they are tracking their marginal rates.



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Inflation is still an issue!

Inflation is still an issue, as the cost of living increases by 25% over the next 10 to 15 years, their normal income levels will begin to push them closer to and then into The Hump.




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What Can You Do!

  • First: Remember that I am not qualified to give advice on taxes or investing!
  • Also: Remember that the IRS can change the tax code at any time which could easily make all of these suggestions irrelevant!
  • Use the URL at the start of these slides to download your personal copy of the spreadsheet.
  • Using today’s dollars, estimate all of your income sources for your retirement: Social Security, Pension, and Annuity.
  • Some of your sources will come from personal accounts: Standard IRA, Roth IRA, personal investments, etc.
  • Use your life expectancy or another estimate of how long your money should last to determine your yearly withdraw amounts.
  • Use the spreadsheet to take a snapshot picture of your personal hump and then take a guess at the amount of COLA inflation that you should add based on time to retirement.
  • Take this to your tax accountant and also your investment advisor to ask advice on its accuracy and steps you might take to improve your situation.
  • Re-do your estimates yearly to see what changes you need to make to your plan.


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Pre-planning with Roth Conversions is an option, let’s look at some numbers!

The combined income of the current couple was $140,000, less $14,000 (10% 401K) and $23,100 (standard deductions and exemptions). That leaves $102,900 taxable which is $48,300 under the top of their 25% bracket. If they converted $45,000 a year from Standard IRA to Roth IRA less the Ferderal 25% taxes $11,250, their Roth will grow by $33,750 per year.

If they do this for 6 years from age 62 to 68, not including inflation and growth, they would have $202,500 of tax free income available during retirement at a cost of $270,000. This could be withdrawn at a rate of $8,100 a year for 25 years.





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Non-taxable Income

During retirement they could reduce their IRA withdrawals by $11,263 per year and keep the same after tax income. The actual cost was $10,800, so the $463 savings is hardly worth mentioning. The important issue is that their taxable income is now considerable below the start of The Hump. That first cruise would now cost only about $11,000 instead of $13,400 and inflation will not quickly put them up against their hump.

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Annuity vs Pension

I talked to my ex-employer’s pension benefits department to get the following information. Don’t trust the options I am about to talk about, call your employer to find out what your personal options are.

When you are given the opportunity to start your pension, you are usually given three options, start a monthly pension amount for the rest of your life, start a joint survivor monthly amount that ends when you and your spouse are both deceased, or take a lump sum distribution. The lump sum can be given to you in cash on which you will have to pay taxes, transferred to an IRA with no taxes, or transferred to a Roth after taxes are paid.

The size of your pension is basically equivalent to the size of the annuity that you can purchase for the lump sum amount.

If you are in a situation where your combined Social Security benefits plus your company pension will put you in The Hump, you might consider transferring your lump sum pension to a Roth account where you can then purchase a tax-free annuity.



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1 or 2 Pensions

Assuming that all of your retirement income will come from Social Security and your Pensions: using Federal Taxes only for all calculations, the transfer of your lump sum pension to a Roth account would cost you 25% in taxes so your Roth tax free annuity would be about 25% less than your taxable pension. Note how the yellow 2 pension gross income is well into The Hump and the red 1 pension 1 tax free annuity puts your taxable gross well out of The Hump. This increases your after tax income by $3,947.


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FYI: How To Copy Charts

If you "Insert..." a new tab, then copy "cntrl-A cntrl-C" everything from the old tab and paste it "cntrl-V" in the new tab, the graphs on the new tab will point to the data on the old tab!

The correct way to do this is to right click on the tab you want to copy and select “Move or Copy...” from the pop up. Check “Create a copy” on the “Move and Copy” popup, select the appropriate tab where you want the new tab created from the “Before sheet” list, and hit [OK]. The charts on the new tab will now properly point to the data of the new tab.



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Other Options

  • Again, I am not an investment advisor!
  • What if you contributed the minimum amount to your 401K so that you will still maximize your company’s match, which is always an important thing to do, it is free money! Then, use the extra after tax income to fund a Roth IRA which will be a non-taxable source after you retire. You would be paying 25% Federal taxes today instead of 27.75% or higher during retirement: if the tax laws are not changed!
  • If your pension is going to be large and push you into the hump, maybe you can take a portion of your pension in a lump sum, pay the taxes at pre-retirement rates now instead of the hump rates later, and invest the lump sum portion in the market or a tax free annuity.
  • Pay off your mortgage before retiring. One way to minimize your monthly expenses is to pay off your mortgage before retirement. Your mortgage is usually your biggest monthly bill, and if you can get rid of that, you’ll have much more flexibility in retirement. It’s too bad that more and more people are carrying a mortgage into retirement. It’s more difficult to minimize tax if you need to withdraw a large amount to pay your monthly mortgage.
  • Dividend income and long-term capital gains. Qualified dividend income is taxed at zero percent, 15 percent or 20 percent depending on your tax bracket. If you can stay under the 15 percent tax bracket, your dividend income won’t be taxed. Long-term capital gains are also taxed at the same rate as dividends.






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The 55.5% marginal rate is not a bad thing!

Note that the blue marginal tax line starts later than the red marginal tax line because the Long Term Gains are tax free until they are pushed into the 25% standard bracket.



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Using Long Term Gains and Dividends to reduce your taxes

The Marginal tax brackets we face during retirement are extremely different than the federal tax brackets we are familiar with during our working lives. Understanding the differences can literally save you thousands of tax dollars every year if you do the proper retirement planning.

In previous sections we have focused on how to avoid The Hump where the 25% federal bracket interacts with the 85% taxability bracket causing marginal tax rates of 55.5% and 46.25%.

If you are trying to take extra money out of your traditional IRA to avoid The Hump as inflation increases COLA, they best way to invest the money you take out is a Roth conversion where all future income will be tax free.

If you are being forced to take minimum withdrawals from your IRA, you are not allowed to move that income into a ROTH unless you have a part time job and can contribute that income to a Roth where the contribution are currently maxed out at $6,500.

The next slide talks about the income that you can’t place in a Roth.






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How much tax can you save?

If you are basically forced to place your extra cash in a savings or brokerage account, one way to pay less taxes on the income generated by those investments is to take the income as either Long Capital Term Gains or Qualified Dividends.

Normal Income SS benefit
Taxability
LTCG / QD Income
Savings
Federal Bracket Marginal BracketFederal Bracket Marginal Bracket
15% 15% 0% 15% 0% 15%
15% 27.75% 85% 15% 12.75% 15%
15% 50.50% 85% 25% 40.50% 10%
25% 46.25% 85% 25% 36.25% 10%

The money that you originally invested to create this income stream will always remain tax free since you already paid taxed on it. You will only be responsible for the taxes on the gains or losses when you sell the investments.


Use the down and up arrows to view the graphical details of this table.




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Normal Taxation Before Retirement


Prior to retirement, while in the 15% bracket, additional Long Term Gains and Dividends are
tax free unless you push some of them into the 25% bracket.

Note that the dotted blue line indicates where your gains are pushed into the normal (green)
25% bracket and are then taxed at the reduced 15% rate.

In that section note how an additional dollar of gross income is still taxed at the 15% level,
the dotted blue line, but that is also causes a dollar of your gains to become taxable at 15%,
and 15% plus 15% is 30%, the solid blue line over the green line!



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Taxation while getting Social Security Benefits


The green line represents your marginal taxes without Long Term Gains and Dividends while the blue line represents your taxes with those gains.
The dotted green and blue lines are your normal Federal tax rates and the dotted red line represents the 50% and 85% taxability brackets for you Social Security Benefits.

When the dotted green and blue 15% lines combined with the dotted red 85% taxability line,
the result is the solid blue/green 27.75% marginal tax rate line, 185% of 15%.

When the green and blue income ticks are both within this area, an actual dollar of LTG/D income is not “taxed”, but it does result in 85% of that gain becoming
taxable Social Security and 85% of the 15% normal bracket is 12.75%.

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Taxation while getting Social Security Benefits


As we cross over into The Hump marginal brackets, a small degree of tax savings still exists.

In this example the 55.5% marginal bracket is reduced to 40.50%, a 15% tax savings because the gains and dividends were initially tax free as illustrated by the gap between the green and blue lines as your marginal taxation starts.

But the marginal 40.50% tax rate should be avoided and we will discuss that further on upcoming pages.



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Taxation while getting Social Security Benefits


As you move past the 55.5% marginal rate, increases in your Long Term Gains and Dividends create a marginal tax rate of 36.25% because the gains themselves are taxed at 15%, not 25%.






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Taxation while getting Social Security Benefits


If the increase in income was from ordinary income not from gains or dividends, then you would pay the full 46.25% marginal rate.






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Conclusion

The bottom line here is simple. The 55.5% and 46.25% marginal tax brackets DO EXIST under today’s current tax laws!

It is a good idea to look at your potential retirement income sources as soon as possible. Use the spreadsheet or other methods to determine what your marginal tax rates will be and how they might affect your retirement lifestyle now and in the future.

Then the choice is yours; take the appropriate steps to avoid the excessively high Marginal Tax Rates or give the IRS back thousands of extra tax dollars.





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