When it comes to the most important social programs for retirees in this country, Social Security is probably at or near the top of the list. Each and every month, more than 42 million retired workers receive a stipend from the Social Security Administration, with 62% relying on this payout to account for at least half of their income. Given the poor saving habits of working Americans, leaning on Social Security during our golden years has become all too common.
Yet in spite of the critical role Social Security plays during retirement, most folks don't have a very good understanding of the ins and outs of Social Security. How do we know? A 10-question true-false quiz of more than 1,500 people conducted by MassMutual Financial Group two years ago showed that just 28% passed (i.e., got seven or more questions right) and understood basic Social Security concepts. Just one person aced the quiz.
There's a lot that working Americans, and to some extent retirees, don't know about Social Security -- and topping that list just might be its taxable status.
Uncle Sam may have a right to some of your Social Security benefits
Believe it or not, Social Security benefits may be taxable, depending on your income. If you weren't aware of that, you could be in for quite the surprise once you reach the eligible retirement age and begin receiving benefits.
Back in 1983, when the Reagan administration passed the last sweeping overhaul of Social Security via the 1983 amendments, the taxation of benefits was first introduced. The program was running an actuarial deficit over the long term (defined as 75 years), and additional revenue needed to be raised. Among the ways to accomplish this was introducing a tax on Social Security benefits for the well-to-do.
As part of the 1983 amendments, taxpayers whose adjusted gross income, combined with half their Social Security benefits, exceeds $25,000, and couples filing jointly exceeding $32,000, would have half of their Social Security benefits taxed by the federal government at the ordinary rate. A second tier was added in 1993 under the Clinton administration that exposed 85% of Social Security benefits to federal taxation for individual earnings above $34,000, and couples filing jointly in excess of $44,000.
When first introduced, this tax affected around one out of 10 households. As of 2015, it affected 56%, according to The Senior Citizens League. The income thresholds associated with this tax haven't been adjusted in 34 years, meaning new seniors are being added to the tax pool with each passing year.
These states may tax your Social Security benefits, too
But that's not the end of the surprises for some seniors. In addition to federal taxation, 13 states also tax Social Security benefits to some degree:
- New Mexico
- North Dakota
- Rhode Island
- West Virginia
While no senior wants to face the added prospect of having to pay tax to his or her home state on Social Security benefits, not all of these states are on equal footing. For example, Missouri allows individual taxpayers to earn up to $85,000 in adjusted gross income (AGI), and couples $100,000 in AGI, before they'd owe any tax on their Social Security benefits. Since most retirees aren't receiving working wages, it means most won't owe any state tax if they live in Missouri.
The same can be said for the likes of Rhode Island, Kansas, and Connecticut. These states offer Social Security tax exemptions for individual taxpayers up to $80,000, $75,000, and $50,000 in AGI, respectively. Most folks will be spared from having to pay any tax on their benefits in these states.
The four least tax-friendly states for Social Security recipients
Then again, four states on the list -- Minnesota, North Dakota, Vermont, and West Virginia -- mirror the federal government's exemption scale. In other words, these four states tax up to 50% of benefits if earnings surpass $25,000 for an individual and $32,000 for a couple filing jointly, or up to 85% of benefits once they exceed $34,000 for an individual or $44,000 for a couple.
These four states can really punish their retirees from a financial perspective. For instance, Social Security recipients in Minnesota not only have to deal with possible state taxation, they also can have their pensions taxed, unless they're from the military. What's more, individual retirement accounts (IRAs) and 401(k)s are taxable. Were this not enough, the average property tax is a bit higher than the U.S. average, the average state and local tax is a whopping 7.27%, and effective income-tax rate is 5.8% for individuals and 6.6% for joint filers! Long story short, Minnesota isn't too friendly to Social Security beneficiaries.
You won't get much love from Vermont, either. Vermont has an average state and local tax rate of 6.17%, and according to Kiplinger it has the ninth highest property tax rate in the country. It also has pretty limited deduction limits, and a high income tax rate of 8.95% on taxable income over $416,700 for single filers, meaning the wealthy really get hammered. To boot, most retirement income is taxable, including 401(k)s, IRAs, and pensions.
North Dakota and West Virginia are slightly less terrible, but still not very friendly. West Virginia allows IRAs, 401(k)s, and pensions to qualify for the retirement-income exemption, and it sports a below-average property tax. Still, it has a combined state tax rate of 6.29%, and it'll levy a 6.5% income tax on income over $60,000!
As for North Dakota, it taxes all forms of retirement income and offers no retirement income tax breaks for seniors. It also has a high combined state sales tax rate of 6.78%. On the plus side, the state's income tax rate is exceptionally low, with an effective income tax rate for single filers of just 1.1%, and a middle-of-the-road property tax rate that does have exemptions available to seniors aged 65 and older.
Nevertheless, if you find yourself retiring in any of these four states, understand that the deck is stacked against you.