What You Need to Know about Social Security Income Taxation

What You Need to Know about Social Security Income Taxation

Today, more than 64 million people receive a monthly Social Security benefit, with the average retired worker receiving more than $1,500 each month as a supplement to other sources of savings. Plus, research has shown that the Social Security benefit has helped pull more than 15 million retirees out of poverty.

Many people recognize Social Security as the most successful social program in the history of the United States. However, the payment may come with some unexpected strings, especially the possibility of taxation. While not everyone will need to pay tax on Social Security payments, understanding liability is important to be able to budget properly.

How the Federal Government Taxes Retiree Social Security Income

The last major overhaul to the Social Security program was completed in 1983 under the Reagan administration. This overhaul included revisions proposed by both Republicans and Democrats. Notably, Republicans pushed for long-term outlay reductions through a gradual increase in full retirement age and the Democrats achieved important increases in revenue generation. The biggest change that happened with this revision was the introduction of taxation for the benefit. Individuals receiving Social Security first faced taxation in 1984, but not everyone gets taxed on it. Ultimately, only people who remain high earners in retirement will need to pay these taxes.

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The Social Security Amendments of 1983 laid out the taxation policy, which is the same guideline used today. Ordinary federal income tax rates can be applied to up to half of a Social Security benefit depending on total income level. Originally, the tax applied to an individual or a couple with a modified adjusted gross income including one half of the Social Security benefit exceeded $25,000 or $32,000, respectively. This tax policy was expanded in 1993 under the Clinton administration with the addition of a second tier. Using the same formula, individuals would get taxed on up to 85 percent of Social Security benefits if income was greater than $34,000 for an individual or $44,000 for a couple.

Unfortunately, the income rates set in 1983 and then in 1993 have never been adjusted for inflation. In other words, while the tax initially applied to relatively few retirees, more seniors were forced to pay the tax over time. According to nonpartisan advocacy group the Senior Citizens League, about half of all retirees now pay the tax on Social Security benefits.

Planning for State Taxes on Social Security Income in Retirement

Retirees should also know that 13 states currently tax Social Security benefits. So not only are retirees living in these states potentially on the hook for federal taxes on their Social Security, but they must also take any state taxes into account. The states that tax Social Security are:

  • Colorado
  • Connecticut
  • Kansas
  • Minnesota
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • North Dakota
  • Rhode Island
  • Utah
  • Vermont
  • West Virginia

Fortunately, four of the states on the list—Vermont, North Dakota, Minnesota, and West Virginia—recently changed their policies to be friendlier for retirees. Only a couple of years ago, these four states had taxation policies that were very similar to the federal policy. For that reason, they were among the least desirable states for retirees. Luckily, all four now have exemptions or higher thresholds that make the tax better for retirees. Furthermore, West Virginia is set to abandon its taxes on Social Security income by 2022.

Some of the states that tax Social Security benefits require retirees to make quite a bit of income before the tax applies. For example, Missouri only taxes benefits for single filers making more than $85,000 and couples making more than $100,000 in adjusted gross income. Plus, Missouri also has partial exemptions for people who earn about these thresholds while claiming the benefit.

Rhode Island is also a rather generous state when it comes to taxing Social Security income. Residents are only subject to the tax after earning more than $81,900 for single filers and $102,400 for couples. Since each state has its own policies, it is important to do some research in the years leading up to claiming the benefit. Sometimes, individuals can make adjustments to their financial situation to avoid tax.

The local tax agencies in the nine other states will have more information about their individual policies and what residents can expect in terms of tax rates. You can also stay on top of your taxes by choosing to withhold a set rate from your monthly payments to cover what you will owe. Unfortunately, the federal government does not allow individuals to set a flat withholding rate and only offers a handful of percentage options: 7 percent, 10 percent, 12 percent, and 22 percent. Before choosing the appropriate percentage rate, you need to know your likely liability in terms of both federal and state tax rates. Another option for staying on top of taxes is paying quarterly rather than annually.