Senior citizens have plenty to worry about in retirement. At the top of that list, however, is getting the most out of Social Security.
The Social Security program was designed to provide a financial foundation for our nation's retired workers, and it's been paying out benefits to workers for more than 75 years. Based on a poll conducted by Gallup in October 2015, a majority of seniors are heavily reliant on Social Security income to meet their month-to-month expenses.
Some 59% of respondents in Gallup's survey described Social Security as a major source of monthly income, with another 31% noting it was a minor source of income. Thus, if seniors aren't able to get the most out of Social Security, up to nine in 10 could be cheating themselves out of the income they need and deserve in retirement.
Most Americans are fully aware that holding off on claiming benefits helps increase what they'll eventually be paid on a monthly basis. But what many Americans overlook is the impact of Social Security taxes.
Mind the taxes
Even if you've paid into the system via the payroll tax for decades, it's likely that you'll wind up paying tax on your Social Security benefits during retirement -- at least according to estimates from the The Senior Citizens League, or TSCL. Based on TSCL's estimates, 56% of Social Security households could owe federal income taxes on their Social Security benefits in 2015. Much of this tax liability stems from the fact that Congress hasn't adjusted the income levels that expose seniors' Social Security benefits to taxation since 1983.
For individual taxpayers, income below $25,000 exempts seniors from having to pay any tax on their Social Security benefits. If Social Security is your sole source of income, and you're earning less than $2,083 a month, you're in the clear. However, people earning between $25,000 and $34,000 could have up to half of their Social Security benefits exposed to federal income taxes. If you happen to earn more than $34,000, up to 85% of your Social Security benefits could be subject to taxation.
Couples face the same scenario, with the exception of slightly higher income ranges. Joint filers with less than $32,000 in income are free from federal taxation on their benefits. However, income between $32,000 and $44,000 could subject joint filers to federal taxation on up to half of their Social Security benefits, while income above $44,000 could mean up to 85% of joint filers' benefits are subject to taxation.
But this isn't all.
States may want their fair share, too
Seniors also need to be aware that certain states also tax Social Security benefits. These 13 states are:
- New Mexico
- North Dakota
- Rhode Island
- West Virginia
Yet here's the thing about states that tax Social Security benefits: They're not all alike. Four, in particular – Vermont, North Dakota, Minnesota, and West Virginia – tax seniors at the same rate as the federal government. In other words, these states aren't exactly retirement-friendly in this aspect, and thus could deprive seniors of hard-earned money during their retirement.
The remaining nine states have varying degrees of exemption levels. For instance, Kansas offers a generous state exemption on taxing Social Security benefits of up to $75,000 in income. Missouri is even more attractive for seniors, with exemptions on adjusted gross income of up to $85,000 for individuals and $100,000 for joint filers. In other words, if you retire in a tax-friendly state that doesn't tax Social Security benefits, or one with an exceptionally high income exemption, you can probably keep more of your benefits during retirement.
Don't forget about tax-free income
The best way to get the most out of Social Security is to ensure that you're using the most tax-savvy strategy to boost your income -- namely, the Roth IRA.
There are a number of effective ways to save for retirement, including a personal investment account through a brokerage firm, as well as a 401(k) through an employer. However, a 401(k) is a tax-deferred account, meaning that, when you begin making withdrawals during retirement, you'll have to pay ordinary taxes on the income.
If you tack your Social Security benefits on top of that income, you could wind up paying quite a bit in taxes. To be clear, I'm not saying a 401(k) is bad by any means; but I am saying that you'll need to be prepared for the tax consequences of a tax-deferred retirement account later in life.
A Roth IRA is a completely different beast. There are no upfront tax benefits with a Roth IRA, and you'll not be allowed to withdraw investment gains from your IRA for at least five years (assuming you're at least 59-1/2, and can make an eligible withdrawal without facing a penalty).
The advantage, though, is that investment gains in a Roth IRA are completely tax free for life. Any money you take out of a Roth during your retirement will not count toward your annual income. If you start saving early and amass a small fortune in your Roth, you can withdraw as much as you'd like annually without it affecting your Social Security tax liability.
Sometimes, the simplest planning can go a long way to protecting your hard-earned income in retirement. When preparing for your retirement, don't forget to mind the taxes.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
More from The Motley Fool
Most Americans Made Poor Financial Decisions This Holiday Season
Were you one of them?
4 Ways to Save More in Your 401(k) in 2018
Annual 401(k) contribution limits are going up next year, and it pays to take advantage.
How 1 Senator Got a Bigger Tax Break for Families
Pressure led to an increase in a key tax credit. Find out more about it here.