Are Social Security Benefits Subject to Income Taxes?

Social Security is a federal old-age, survivors, and disability insurance program administered by the Social Security Administration (SSA). It offers retirement benefits and disability income to qualified people and their family members, including spouses, children, and survivors. To qualify for Social Security retirement benefits, individuals must be at least 62 years old and have contributed to the system for at least ten years. The benefits given in retirement can vary from person to person and are calculated based on an individual’s Average Indexed Monthly Earnings (AIME) during their 35 highest-earning years. In addition to retirement benefits, Social Security also provides financial assistance to those unable to work because of a disability and surviving spouses and children who meet specific requirements. Like other forms of income, you are taxed on your Social Security earnings. However, this may differ based on a few factors.

A financial advisor can help you understand whether or not you will be paying taxes on Social Security benefits in retirement. This article will discuss the situations where Social Security is taxed and how to minimize your taxability in retirement.

Is Social Security taxable?

There is some confusion about whether Social Security benefits are taxable. A lot of people may be exempt from paying income tax on Social Security, but the truth is, for most individuals, a portion of their Social Security income will be subject to income tax. Social Security income tax depends on your total combined income from various sources, such as pension plans, investment returns, wages, salaries, bonuses, etc.

Here are some details to help you better understand how Social Security taxation works:

Social Security income tax thresholds

When it comes to Social Security benefits, the Internal Revenue Service (IRS) has established specific thresholds to determine the taxable portion of your income. The percentage of benefits subject to taxation varies based on your filing status and combined income. Here’s a breakdown of how this works:

For single tax filers:

• If you are a single tax filer with a combined income that falls between $25,000 and $34,000, up to 50% of your benefits may be taxable.
• If your combined income exceeds $34,000, up to 85% of your benefits may be subject to taxation.

For married joint tax filers:

• For couples filing jointly, if your combined income is between $32,000 and $44,000, up to 50% of your benefits may be taxable.
• If your combined income exceeds $44,000, up to 85% of your benefits may be subject to taxation.

However, an important point to note is that even if you fall within the income ranges mentioned above, not all of your Social Security benefits will be taxed. The maximum taxable portion is capped at 85% of your total benefit amount. Suppose you are an individual filer, and your total combined income, including your Social Security benefits, is $50,000 per year. According to the IRS guidelines, this income level falls within the range where up to 85% of your benefits may be subject to taxation. Assuming your annual Social Security benefit is $25,000, you will be taxed on 85% of this value, i.e., $21,250 of your Social Security benefits. The remaining 15% of your benefits, which amounts to $3,750, would not be subject to income tax. Your overall tax liability would depend on various factors, including your other sources of income, deductions, and applicable tax rates in the concerned financial year.

How is Social Security tax calculated?

Now that you know Social Security benefits are taxable, let’s understand how your tax liability is calculated.

To determine the taxable portion of your Social Security benefits, the IRS considers several factors, such as the following:

• Adjusted Gross Income (AGI): The tax liabilities of your benefits are calculated based on your AGI, which includes income from various sources such as wages, self-employment earnings, interest income, dividends received from investments, Required Minimum Distributions (RMDs) from retirement accounts, and other taxable income.
• Tax-exempt interest: Even though tax-exempt interest is not subject to taxation, it is used when calculating your Social Security income tax. You need to add it to your AGI for the year. 
• Income thresholds: If your total income exceeds the minimum taxable levels, at least 50% of your Social Security benefits will be considered your taxable income.
• Deductions: You can choose between the standard deduction and itemized deductions to arrive at your net income in the final step. Moreover, your exact tax liability will depend on where your income falls within the federal income tax tables.

 

You can use the Social Security Benefits Worksheet available on the official Internal Revenue Service (IRS) website to determine your tax liability.

Do you pay federal taxes on Social Security on spousal, children, and other benefits?

Yes, you may owe taxes on other types of Social Security benefits. Spousal, survivor, disability, or Supplemental Security Income (SSI) benefits can all have their own set of rules regarding taxation.

Here’s how each of these is taxed:

1. Spousal Social Security benefits

If you receive spousal Social Security benefits, the taxation rules are the same as for other Social Security recipients. If your income exceeds $25,000, you may owe taxes on up to 50% of the benefit amount. However, if your income surpasses $34,000, the taxable portion increases to 85%.

2. Survivor Social Security benefits

Survivor benefits are paid to children, so they are hardly ever subject to taxation, as most children do not have other income sources that can put them in a taxable slab. Further, if a parent or guardian is receiving these benefits on behalf of the children, they are also not required to report the income as part of their own income for taxable purposes.

3. Disability Social Security benefits

Disability benefits are subject to the same taxation rules as the normal Social Security benefits. The taxability of these benefits depends on the recipient’s gross income. If an individual’s gross income exceeds $25,000, 50% of the benefit amount will be taxed. If a couple’s combined gross income exceeds $32,000, benefits of up to 85% may be taxable.

4. SSI Social Security benefits

SSI is designed for disabled individuals, such as people with physical and mental disabilities or those aged 65 and above. These benefits are exempt from income tax.

Is Social Security income taxable in all states?

The taxability of Social Security benefits varies across states in the United States. While 38 states and the District of Columbia do not tax Social Security benefits, there are 12 states that do impose taxes on some or all of their residents’ Social Security benefits. Additionally, Colorado has a unique taxation approach, as it only taxes Social Security benefits received by residents under the age of 65 but provides full deductions for recipients aged 65 and above.

The other eleven states that tax some or all of their residents’ Social Security benefits include Connecticut, Minnesota, Missouri, Kansas, Montana, Nebraska, New Mexico, Rhode Island, Utah, Vermont, and West Virginia.

Here are the tax implications for these states:

1. Connecticut: Social Security benefits are taxed at rates ranging from 3% to 6.99%.
2. Minnesota: The tax on Social Security income ranges from 5.35% to 9.85%.
3. Missouri: Social Security income is subject to a tax rate of 4.95%.
4. Kansas: Social Security benefits are subject to state income tax ranging from 3.1% to 5.7%.
5. Montana: The tax rate on Social Security income ranges from 1% to 6.75%.
6. Nebraska: The tax on Social Security ranges from 2.46% to 6.64%.
7. New Mexico: Social Security income is taxed at a rate of 1.7% to 5.9%.
8. Rhode Island: Social Security income is subject to a tax rate of 3.75% to 5.99%.
9. Utah: The state tax rate on Social Security benefits is 4.65%.
10. Vermont: Social Security benefits are taxed at a rate ranging from 3.35% to 8.75%.
11. West Virginia: The tax rate on Social Security income ranges from 3% to 6.5%.

How to lower your taxability from Social Security benefits

While you cannot completely eliminate Social Security income tax, you can find ways to lower your taxability. Here are some steps that can help:

1. Explore tax-advantaged retirement accounts

One effective strategy to minimize the taxability of your Social Security benefits is to consider utilizing tax-advantaged retirement accounts, such as a Roth IRA or 401(k). These accounts offer unique tax benefits that can help reduce your overall tax liability. Contributions made to Roth accounts are made with after-tax dollars. This implies you have already paid taxes on the money before it was deposited into the account. As a result, qualified distributions from Roth IRAs and Roth 401(k)s are tax-free. Since taxes were taken when the contributions were made, these distributions are not subject to additional taxation. This can be advantageous in minimizing the taxable portion of your Social Security benefits. In contrast, withdrawals from traditional IRAs or 401(k)s are subject to income tax because the contributions to these accounts were made with pre-tax dollars. This means that 100% of the withdrawals from traditional retirement accounts will be taxed as income, potentially increasing the taxable portion of your Social Security benefits.

You can consider converting funds from a tax-deferred retirement account to a Roth IRA before retirement. Although you will pay income tax on the converted amount, all your subsequent distributions will be tax-free and will not count towards your income calculation for Social Security benefit taxation.

2. Switch to non-taxable investments

Reviewing your investment portfolio and potentially shifting to non-taxable investments is important, if possible. Investments that generate non-taxable income or income subject to lower tax rates can help you reduce the overall tax burden on your Social Security benefits. For instance, interest income from many bonds is subject to tax. But interest income from municipal bonds is generally exempt from federal and state income taxes. By shifting to municipal bonds, you can lower your tax output without messing with your portfolio’s asset allocation.

Before making any decisions, make sure to evaluate the tax efficiency of your investment portfolio. Diversify your investments to include a mix of taxable and non-taxable income sources. Remember that tax diversification is as important as picking investments with diverse risk levels and returns.

3. Make distributions early

Once you reach the age of 59.5 years, you can make penalty-free distributions from your tax-sheltered retirement accounts without incurring early withdrawal penalties. Unless the withdrawals are from a Roth account, they are generally taxable. To effectively reduce the taxability of your Social Security benefits, it is essential to assess all your income sources, understand the tax implications of different retirement accounts, and strategically time your withdrawals. So since the goal is to pay less tax on Social Security later, you can plan to withdraw more from your other retirement accounts during the pre-Social Security period compared to the period after you begin receiving Social Security benefits. This way, you can potentially optimize your overall tax situation.

4. Delay claiming Social Security benefits 

Another strategy to minimize the taxability of your Social Security benefits is to delay claiming them. If you have outside income and other investments, delaying claiming your Social Security benefits might be beneficial. In the meantime, as mentioned in the previous point, you can be more aggressive in drawing down your other assets, such as retirement savings or taxable investment accounts. By utilizing these assets earlier on, you can potentially reduce the amount of taxable income generated from them in the future. This approach can be advantageous since other assets may be subject to higher tax rates compared to Social Security benefits.

If you withdraw your other assets early, you may have fewer taxable assets when you start receiving your Social Security benefits, lowering your overall tax liability. Moreover, the longer you wait to claim, the more your benefits will increase. Delaying can result in an 8% per year increase in benefits until you reach the age of 70 years.

5. Consult a financial advisor

You can consult with a qualified financial advisor or tax planner to understand the taxability of Social Security benefits in your unique situation. A financial advisor can help you plan your withdrawals to optimize tax and maximize your returns. Since everyone’s income sources differ, it may be beneficial to work with a professional and use their personalized guidance based on your individual circumstances.

To conclude

Paying taxes on Social Security is mandatory at the federal level. Therefore, make sure to plan well and time your distributions optimally. Take out the time to understand how the taxability of Social Security benefits is determined and take proactive steps to comprehend your tax situation. This will help you make informed decisions to maximize your retirement income with minimal tax hassles. Also, remember every individual’s financial situation is different, so seeking professional advice aligned with your retirement goals is crucial.

Use the free advisor match service to find a financial advisor who can help you with retirement planning and tax optimization. Answer some simple questions about your financial needs, and our matching tool will connect you with 1-3 advisors who can best fulfill your financial requirements.

For further insight on how to customize your retirement planning strategies to meet your specific financial requirements, visit Dash Investments, or email me directly at dash@dashinvestments.com.

Sincerely,

Jonathan Dash
Founder and President
Email: info@dashinvestments.com