The Cost of Money
Now that we have a picture of the “Marginal Tax Hump”, what are the taxes that we have to pay during our retirement when we are actually in our Personal Marginal Tax Hump? How much do we have to earn or withdraw from our IRA if we want an extra $100 of spendable cash?
The cost of money also changes significantly based on the perspective that you use to look at the taxes that you pay.
From your Income Perspective, if your income is $100 and your total tax rate is 25%, your cost in only $25, and you will have to live on just $75. If your tax rate doubles to 50%, you pay twice as much tax, $50, and your living income is $50.
If you change your perspective to the money that you get after tax, your Lifestyle Perspective, at 25% your income will have to be $133.33 and the taxes you will pay will be $33.33, so your after tax income will be $100. If your tax rate doubles to 50%, your income will have to be $200 so you can pay $100 in taxes to live on $100.
From the Income Perspective, your taxes doubles from $25 to $50. From your after tax Lifestyle Perspective, your tax rate might have doubled, but the taxes you have to pay tripled, from $33.33 to $100.
Let's look at this example in the real world of Federal, State, and Local taxes, and let's look at it from your after tax personal lifestyle income perspective.
The Tax Hump with Federal Taxes Only
The Tax Hump with Federal, State, Local, plus Sales Taxes
Now let's compare the actual cost in dollars when you have to pay an extra 4.75% State Tax plus 3% Local Tax plus 6% Sales Tax for a total of 13.75%. The extra cost from the $100 income perspective should only be $13.75, but what are the real costs of the extra tax rates when you want to spend $100?
None of the extra tax numbers are anywhere near the extra tax rates which would only cost $13.75 (4.75% MD + 3% Cecil + 6% Sales). The reality is that the extra state and local taxes not only add extra tax money for the state and local governments, but they also amplify the amount of tax that you are paying to the federal government. Let's look at just one number, the highest taxes we pay are for earned income when you are also being taxed on your Long Term Capital Gains. The total Federal taxes, when you are only paying Federal taxes, was $135.85. When we added the extra 13.75% state and local taxes, the total federal tax grew to $176.21 which is a 29.71% increase in the taxes you pay to the federal government!
Before we move on to the next page, let's take one more look at the Payroll Taxes that are being paid in all of these examples:
When you look at the taxes that you are paying from the perspective of the money that you are making or withdrawing from a taxable IRA, the calculations are simple. Payroll taxes on $100 of earned income will always be 6.2% for Social Security, $6.20, and 1.45% for Medicare, $1.45; and always $0.00 for IRA withdrawals. BUT, when you look at these taxes from the perspective of the money you need to get after all of your taxes have been collected by the Taxopus, and you want that after tax number to be exactly $100; your tax rates and the taxes you pay DO NOT just add together, they amplify each other!
In the Payroll Taxes table above, the State and Local taxes are all fixed percentages, but the Extra Cost that those fixed percentage has on your Payroll Taxes is not a fixed number. Each amount has been amplified by the size of all tax rates in each column!
What is the actual cost of Sales Tax?
The calculations for Sales Tax are not the same as the calculations for Income Taxes. They are not based on your amount of Income, they based on your amount of After Tax Income! But, even though the calculations are different, your Sales Tax acts just like every other government tax. You can't just add this new tax rate to your other tax rates, you have to amplify all of your other taxes when you include Sales Tax.
In this example, you only have to pay an extra $6 in Sales Tax, but you have to earn an extra $17.32!
For the Math Geeks in the group, your marginal income tax rate in the first column was 65.35%, so your spendable cash was only 34.65% of your income. $6 in Sales Tax divided by 34.65% equals $17.32 of extra income!
Now that we have seen an example of how much we are actually paying when we are in our personal tax hump, and let's look at how the size of our Social Security benefit interacts with when we start and how long we have to pay these huge tax hump rates.