Each and every month, more than 61 million people receives a payout from the Social Security Administration, and more than two out of three recipients are retired workers. A majority of these elderly retirees leans quite heavily on Social Security to make ends meet, with 62% counting on the program for at least half of their monthly income and 34% relying on it for 90% or more of their income. Without this guaranteed monthly payout, it's fair to say we'd probably have an elderly poverty problem on our hands.

Yet, in spite of the critical role that Social Security currently plays for retirees, and is expected to play for baby boomers in the future, there's quite a bit the average American doesn't understand about it. A 2015 10-question, true-false survey conducted by MassMutual Financial Group on basic Social Security knowledge found that just 28% of the more than 1,500 people who took the quiz got a passing grade of seven correct answers or higher. Only one person aced the quiz. 

Though it may sound a bit cliche, the reality is that what you don't know about Social Security can come back to bite you in the wallet during your golden years.

Two Social Security cards partially covering a hundred dollar bill.

Image source: Getty Images.

Seriously, you can be taxed on your Social Security benefits

Arguably one of the biggest surprises seniors receive when they retire is discovering that their Social Security benefits may be taxable. The taxation of Social Security benefits generated $32.8 billion for the program in 2016, or a bit more than 3% of total revenue.

Back in 1983, as part of the Social Security Amendments passed by the Reagan administration to close an actuarial deficit in the program, the taxation of benefits was introduced. Single taxpayers earning more than $25,000 annually, and couples filing jointly with more than $32,000 in earned income, could have 50% of their Social Security benefits taxed at ordinary federal income-tax rates. A separate tier was added in 1993 under the Clinton administration for single filers earning above $34,000 and joint filers above $44,000. These folks can have 85% of their Social Security benefits exposed to federal income-tax rates. 

When introduced, this tax impacted about one in 10 households with a Social Security recipient. As of 2015, it impacted 56% of households, according to The Senior Citizens League. Despite this amendment being passed 34 years ago, the income thresholds have never been adjusted upward to account for inflation, meaning you have a better chance than not of owing at least some federal tax on your benefits.

An angry young man sitting at his desk with his arms folded.

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36 million Americans may owe state tax, too

I wish I could say that's the last of the surprises come tax time when it comes to Social Security benefits, but it's not. There are also 13 states that tax Social Security benefits to a varying degree.

The following four states mirror the federal tax schedule described above:

  • Minnesota
  • North Dakota
  • Vermont
  • West Virginia

Additionally, nine other states tax Social Security benefits, although they offer some varied degree of income exemptions.

  • Colorado
  • Connecticut
  • Kansas
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • Rhode Island
  • Utah

If we add together the residents (elderly, adult, and children) of each of these 13 states, and we also assume that state law governing the taxation of Social Security remain static, up to 36.2 million people could find themselves subject to paying tax on their benefits to their state.  Understandably, not everyone is going to qualify for Social Security benefits, and there's always a chance these states alter their laws governing the taxation of benefits. Nevertheless, that's a lot of people who could be in for a shock when they realize their Social Security payout isn't as much as they thought it'd be because of state and federal taxation.

A Social Security card next to an IRS 1040 tax form, a pair of glasses, and a twenty dollar bill.

Image source: Getty Images.

Residents in a few taxing states get big breaks

Now, it's not all bad news if you live in some of these states. A handful have such high income exemption levels that very few seniors will actually owe tax to their state (of course, they may still owe at the federal level).

For example, Missouri, Rhode Island, and Kansas, offer the highest income exemptions with regard to state-level tax on Social Security benefits. Single filers can earn up to $85,000 in adjusted gross income (AGI) in Missouri, up to $80,000 in AGI in Rhode Island, and up to $75,000 in AGI in Kansas, and still not owe any additional tax on their Social Security benefits within their respective states. Couples in Missouri and Rhode Island are also exempt with AGI's under $100,000. If you live in a state with a high income exemption, then you can breathe a little easier.

On the other hand, residents in the four states that mirror the federal schedule get few, if any, breaks from Social Security taxation.

Understanding how your state taxes Social Security benefits (and retirement benefits as a whole) may be critical to your financial well-being during your golden years.