As a retiree, it’s important to plan for all costs that you’ll incur — including taxes. Unfortunately, it comes as a surprise to many seniors that the federal government and some state governments tax Social Security benefits.
Whether you’re currently receiving Social Security checks or plan to in the future, there are three key rules you should know so you’re prepared for the impact that your tax bill will have on your retirement budget.
1. The IRS taxes you on benefits after countable income exceeds a certain threshold
Federal rules on taxation of benefits are the most important for seniors to be aware of because these apply throughout the United States.
Under these regulations, Social Security benefits are taxable only after countable income — also called provisional income — equals or exceeds a certain threshold. Countable income specifically refers to ½ of Social Security benefits combined with certain types of non-taxable income (such as interest on MUNI bonds) as well as all taxable income including IRA and 401(k) distributions from traditional accounts.
Here are the thresholds at which your benefits become party taxed, based on your countable income:
- Up to 50% of benefits will be taxed once provisional income equals or exceeds $25,000 for single tax filers or $32,000 for married joint tax filers
- Up to 85% of benefits will be taxed once provisional income equals or exceeds $34,000 for single tax filers or $44,000 for married joint tax filers.
It’s important retirees note that Roth IRA and Roth 401(k) distributions do not count when provisional income is calculated. As a result, those who wish to avoid federal tax on Social Security benefits may prefer to invest most or all of their retirement funds in these accounts to ensure their provisional income doesn’t exceed these thresholds.
2. The threshold at which benefits become taxable isn’t indexed to inflation
When federal taxes on Social Security benefits were first put in place, only a small percentage of seniors owed them. Now, close to half of all retirees pay taxes on part of their benefits, according to recent data from the Senior Citizens League. And more will in the future.
The reason for this is simple. The thresholds at which benefits become taxed are not indexed to inflation. They have remained the same for decades. And they will not change going forward without a change to the law by Congress.
Since retiree incomes go up over time due to the effects of wage growth, more seniors each year end up with a countable income that results in taxation of benefits. Future retirees should plan and prepare for the likelihood they too will lose part of their Social Security checks to the IRS. .
3. 13 states also tax benefits
The majority of Americans only need to know federal tax rules because their states do not impose taxes on benefits. However, 13 states do tax Social Security for at least some seniors. These include:
- Colorado
- Connecticut
- Kansas
- Minnesota
- Missouri
- Montana
- Nebraska
- New Mexico
- North Dakota
- Rhode Island
- Utah
- Vermont
- West Virginia
Each of the above-named states has their own rules for taxing benefits. The links lead to the website of each state’s taxing authority so seniors can check the guidelines that apply where they live. In most cases, low income retirees are exempt from state tax on at least part of their Social Security income. As a result, state taxes on benefits are primarily a concern for middle class and wealthy retirees.
By learning both the state and federal rules for taxation of benefits, current and future retirees can make a more informed assessment of how far their after-tax Social Security benefits will go to provide for their needs.
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