Social Security is arguably America's most important social program. However, it's also a program that most folks don't understand very well -- and surveys prove it.

Earlier this year, MassMutual Financial released the findings of a five-question, true–false survey on Social Security. Of the 1,007 seniors aged 50 and up that were surveyed, 47% failed the quiz (i.e., answered three or fewer questions correctly). Considering that a majority of current retirees lean on the program as a major source of income, the results of this survey are certainly demoralizing. 

Two Social Security cars lying atop and partially covering a hundred-dollar bill.

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While there are a number of aspects of Social Security that could easily be called confusing, I'd opine that one of the biggest gray areas in Social Security knowledge relates to the program's two forms of taxation: the payroll tax and the taxation of benefits.

Read on, and you'll find anything and everything you need to know about Social Security taxes.

Social Security's workhorse: the payroll tax

The first of the two Social Security taxes, the 12.4% payroll tax, is applied to earned income (predominantly wage income, but also inclusive of interest and dividend income; does not include investment income or capital gains) of up to $128,400, as of 2018. In simple terms, every dollar earned by workers up to $128,400 this year will be subject to Social Security's payroll tax, while all earned income above $128,400 will be exempt. More than 90% of all workers today make less than $128,400 and are therefore subjected to the payroll tax on every dollar they earn. You'll most likely see this tax on your pay stub under the "FICA" column, since it's part of the Federal Insurance Contributions Act, along with Medicare.

Why is there a cap on what income is being taxed, you ask? The reason is because the Social Security Administration caps the maximum monthly benefit at full retirement age, too ($2,788 as of 2018). Since there's only so high benefit checks can go, the SSA set a cap on the amount of earned income that's taxable. However, the maximum taxable earnings cap increases in step on a percentage basis with the National Average Wage Index. This suggests that the well-to-do should pay more into the system as time passes.

Two Social Security cards lying atop a W2 tax form.

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What you should also know is that most Americans aren't subject to the entire 12.4% payroll tax. If a worker is employed by someone else, their employer will cover half of their Social Security payroll tax responsibility (6.2%). This leaves most working Americans to pay 6.2% of their earned income into the program. But if you're self-employed, you'll owe the entire 12.4% payroll tax.

Last year, Social Security's payroll tax generated $873.6 billion of the $996.6 billion that was collected by the program. It's absolutely Social Security's workhorse, and it's the primary reason the program won't go bankrupt. In essence, as long as the American public keeps working, benefits will continue to be collected via the payroll tax for disbursement to eligible beneficiaries.

Social Security's necessary evil: the taxation of benefits

Unlike the tax on earned income, which targets the existing workforce, the taxation of benefits is targeted specifically at beneficiaries currently receiving a monthly Social Security check.

Introduced in 1984 following the passage of the 1983 Amendments, the taxation of Social Security benefits applies to single tax filers whose adjusted gross income (AGI) plus one-half of their Social Security benefits tops $25,000. For couples filing jointly, this figure is $32,000. Beneficiaries topping these levels of combined income (AGI plus one-half of benefits) can expect to pay federal income tax on half of their Social Security benefits.

In 1993, the Clinton administration approved a second tier that allowed up to 85% of benefits to be taxed if combined income exceeds $34,000 for a single tax filer or $44,000 for a couple filing jointly.

A senior man counting a fanned stack of cash in his hands.

Image source: Getty Images.

When initially implemented, the taxation of Social Security benefits was only designed to impact 1 in every 10 households. However, the income thresholds associated with the taxation of benefits have never been adjusted for inflation. The Senior Citizens League estimates that 56% of senior households are paying some federal tax on their Social Security benefits as of today.

According to the 2018 Social Security Board of Trustees report, the taxation of benefits generated $37.9 billion in 2017.

But this only tells half of the story behind the taxation of benefits.

Some states tax Social Security benefits, too

In addition to the federal taxation of Social Security benefits, 13 states also tax Social Security income to some varied degree. These states are:

  • Colorado
  • Connecticut
  • Kansas
  • Minnesota
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • North Dakota
  • Rhode Island
  • Utah
  • Vermont
  • West Virginia

If your state isn't on this list, consider yourself lucky. It means your state is among the 37 that doesn't tax Social Security benefits. Understand that you could still be liable for federal taxation based on the income threshold noted above, but you won't owe anything to your state.

A senior couple examining their finances on their laptop.

Image source: Getty Images.

Also understand that living in one of these 13 taxing states isn't necessarily bad news. For example, Missouri, Rhode Island, and Kansas don't begin taxing a single filer's Social Security benefits until their AGI crosses $85,000, $80,000, and $75,000, respectively. You'd have to earn a lot to pay tax on your Social Security benefits in these states.

Meanwhile, a few states, such as Minnesota, North Dakota, Vermont, and West Virginia, mirror the federal tax schedule for Social Security benefits. If you owe tax to the IRS on your Social Security benefits, you'll probably be writing a check to your state as well.

While Social Security taxes might seem complicated on the surface, they're actually pretty straightforward once you dig into the details.

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