Social Security is already one of America's most vital social programs for seniors, and its importance only seems to be growing. According to data from the Social Security Administration, more than three out of five seniors relies on their monthly Social Security check to account for at least half of their income. Considering that boomers are retiring from the workforce in greater numbers, life expectancies are increasing, and the saving rate of Americans is pretty poor relative to other developed countries, Social Security's place as America's most important social program is well solidified.
But in spite of being so important, there's a lot that Americans don't understand about Social Security. For example, a 2015 survey of pre-retirees conducted by AARP with the help of The Financial Planning Association found that just 5% knew how much their benefits would increase if they waited until their full retirement age to claim benefits as opposed to age 62 (25% to 30% being the correct answer). Similarly, only 32% of those surveyed were aware that claiming at age 70 would maximize their benefits.
No joke: You'll likely be taxed on your Social Security benefits
But if there's one aspect of Social Security that seems to surprise most people, both young and old, it's that Social Security benefits are taxable. That's right -- earn too much money in a year and you could owe Uncle Sam money based on the benefits you'll receive.
Back in 1983, the Reagan administration passed sweeping Social Security reforms designed to tackle an actuarial deficit in the program. These changes includes a staggered increase to the full retirement age over a four-decade period, higher payroll tax rates on earned income, and the introduction of the taxation of benefits.
Initially the taxation of benefits was only expected to impact about one in 10 beneficiary households. Individuals with more than $25,000 in earned income, and couples filing jointly with more than $32,000 in annual earned income, could have up to half of their Social Security benefits exposed to federal income tax. In 1993, the Clinton administration added another tier, which allowed up to 85% of Social Security benefits to be exposed to federal income tax if an individual earned more than $34,000, or a couple filing jointly more than $44,000, annually.
Since 1983, these thresholds have not been adjusted for inflation. The result, according to The Senior Citizens League, is that 56% of seniors receiving Social Security benefits in 2015 would owe at least some tax on those benefits.
These states offer some hefty Social Security tax exemptions
But the buck doesn't stop with Uncle Sam. In addition to the federal government possibly taxing Social Security income, 13 states also tax Social Security benefits, much to the surprise of current or future retirees.
Some of these states, such as Minnesota, North Dakota, Vermont, and West Virginia, mirror the same tax schedule as the federal government. Others, such as Colorado and Montana, have their own set of income-exemption limits that are relatively low, meaning few seniors get a free pass when it comes to tax time.
However, among the 13 states that tax Social Security benefits, three have exceptionally high income-exemption limits that should allow nearly all seniors to avoid having to pay any tax on their benefits within a respective state. While you'd still owe federal income tax on a portion of your Social Security benefits, these three states aren't as unfriendly to retirees as you'd think.
- Missouri: Residents of Missouri are able to earn up to $85,000 in individual adjusted gross income (AGI), or up to $100,000 in AGI as a couple, before any portion of their Social Security benefits would be taxed by the state. The state also notes that you may still qualify for a partial exemption, even if you earn more than the given AGI thresholds. Missouri's tax exemption limits are the most generous of the 13 states that tax Social Security benefits.
- Rhode Island: Don't let Rhode Island's size fool you, because it's big on income exemptions for retirees. In Rhode Island, individuals can earn up to $80,000 in AGI, and couples filing jointly up to $100,000 in AGI, before they'd owe any tax on their Social Security benefits to the state. If not for Missouri, Rhode Island would be the friendliest "taxing" state of the bunch.
- Kansas: The Sunflower State may not be as generous as Missouri or Rhode Island with its income exemptions, but most retirees are still going to get away without having to pay a cent in tax to the state based on their Social Security income. In Kansas, those with AGI's of $75,000 or less are exempted from having their Social Security benefits taxed. With most seniors not working, this should only affect a very small percentage of the population.
While it'd be nice if the federal government adjusted its tax thresholds for inflation, that's probably not going to happen anytime soon, especially with Social Security facing a cash shortfall over the next 75 years. For current and future retirees, it means you'll need to do your homework to really understand your tax liability from both a federal, and possibly state, perspective with regard to your Social Security benefits.