Is Social Security Taxable?

At the end of a long career, tens of millions of Americans look forward to claiming the Social Security benefits they're entitled to receive. After decades of having Social Security payroll taxes withheld from their paychecks to help fund the monthly retirement benefits of older Americans, workers feel like they've earned their future benefits, and they want to keep every dollar they get from the program.

Yet many new Social Security beneficiaries are surprised to learn that under certain circumstances, a portion of the money they receive from the retirement program can be treated as taxable income, which means they'll have to pay income taxes on it each year. This is especially common among those who continue working while receiving retirement benefits, as their earned income can take them above the income threshold at which the IRS starts taxing Social Security benefits.

Yet even those who have retired for good can lose some of their benefits to taxation, regardless of whether they've reached full retirement age or not. Currently, almost 20 million people have to pay income taxes every year on a percentage of their Social Security retirement or disability benefits, and that number could rise steadily if the current laws governing benefit taxation go unchanged.

Below, we'll go over how much income you can earn before your Social Security benefits become partially taxable, and you'll also learn some of the strategies you can use to minimize or eliminate the tax burden that can come with receiving Social Security payments.

First, though, it's useful to look at the history of how Social Security benefits became taxable in the first place, as that provides some insight into why lawmakers created this controversial tax law and whether there's a chance it could be modified or eliminated in the future.

Image source: Getty Images.

Why Social Security benefits were not originally taxed

Social Security was created in 1935, in the middle of the Great Depression. In 1940, it began paying monthly benefits to retired workers aged 65 and older. At the time, the Treasury Department issued specific tax rulings that made it clear that Social Security benefits were excluded from federal income taxation.

That may not sound like a controversial decision, but it was actually unusual at the time. In general, most private pension payments that retirees get have been at least partially taxable, even if employees' contributions toward those pensions were subject to tax throughout their careers.

Social Security also has the special characteristic of getting its funding from both employee and employer contributions. Workers aren't taxed on the money their employers pay in payroll taxes, so when retirees get their benefit payments, the portion that came from their employers' tax payments should, arguably, be fully taxed, as it wasn't previously included in the worker's income.

However, the Treasury considered the benefits to be gifts, rejecting the idea that they were directly tied to the payroll taxes that funded the benefits. That made sense at the time, since workers paying into the system for the first time were not yet eligible for benefits, and those retirees who could get Social Security generally hadn't paid much in payroll taxes.

Social Security's first funding crisis leads to tax change

That all changed in the late 1970s, when Social Security went through its first round of major financial difficulties. Starting in 1979, an advisory council on Social Security reform suggested taxing 50% of Social Security benefits, arguing that was more in line with how other types of retirement-related income got taxed. Lawmakers didn't like the idea of imposing tax on every retiree, so they proposed letting low-income retirees be exempt from the measure.

Further recommendations came in the early 1980s from future Federal Reserve chair Alan Greenspan's National Commission on Social Security Reform, which adopted a similar methodology to what had been proposed early on. In the end, the rules that lawmakers adopted in 1983 forced Social Security recipients to include some of their Social Security benefits in taxable income if their "combined income" -- that is, their adjusted gross income on their tax return plus tax-exempt bond interest and one-half of their annual Social Security benefits -- was higher than $25,000 for single filers or $32,000 for joint filers.

How Social Security gets taxed today

A decade later, Congress once again took up the issue of Social Security taxation and made its most recent revisions. Lawmakers proposed adding a second set of thresholds above which a greater percentage of Social Security benefits would potentially be subject to tax. In particular, for single filers making more than $34,000 in combined income, or joint filers making more than $44,000, as much as 85% of Social Security benefits could be subject to tax.

The exact amount that's subject to tax gets complicated because of this new set of thresholds. As you can see on this IRS worksheet, it takes 18 lines' worth of calculations to figure out how much of your benefits will be subject to tax under these rules. At the risk of oversimplifying, though, most people will see the percentage of their benefits that are taxed rise gradually from 0% to 50% as their income rises from the lower threshold to the upper threshold. Above the upper threshold, the percentage included will keep increasing gradually, eventually reaching 85% if their income is high enough.

These provisions passed in 1993, and they haven't been changed since. This table shows you how much income you can earn currently before part of your Social Security benefits could be subject to federal income tax.

Source: IRS.

These income thresholds were stated definitively in the law, with no provisions for any future changes to them. Unlike the majority of key federal income tax provisions, the numbers aren't subject to inflationary adjustments to keep up with the rising cost of living. Because incomes have also gone up steadily over time, that means is that as time goes by, it's more likely that your income will move above these thresholds, forcing you to pay tax on some of your Social Security benefits.

Some examples of how benefits get taxed

It's easier to see how the rules apply when you consider a simple example. Take a single person who gets $1,000 a month from Social Security, another $1,000 from investment income, and $1,000 from withdrawals from a traditional IRA. When you do the math, this person has $36,000 per year in total income. But for the purposes of determining combined income for taxing Social Security income, you only take half of the $1,000 in monthly Social Security benefits, along with the full amount of outside taxable income from investments and the IRA. Half of the $12,000 in Social Security is $6,000, and after you add the other $24,000 in investment and IRA income, the combined income amount comes to $30,000.

That $30,000 number is above the $25,000 initial income threshold for Social Security taxation. That means that theoretically, the person could be required to include up to half of total benefits, or $6,000, as taxable income. However, because the $30,000 income number is only $5,000 above the initial threshold, the lower amount of one-half of $5,000, or $2,500, is actually subject to tax.

The results are much different when you have someone with higher income levels. To keep things as simple as possible, take the same example above, but assume that in addition to the income listed above, the person is also still working and earns $2,000 a month from employment. That raises the combined income amount by $24,000 annually, bringing the total to $54,000.

$54,000 is well above the $34,000 upper threshold above which up to 85% of benefits can get taxed. Here's the simplified version of how to calculate the exact amount to include, using the IRS worksheet referred to above:

• Take one-half of the difference between the $34,000 upper threshold and the $25,000 lower threshold. Half of $9,000 is $4,500.
• Take the excess income above $34,000 and multiply it by 85%. $54,000 minus $34,000 is $20,000, and 85% of $20,000 is $17,000.
• Add together the two numbers above. $4,500 plus $17,000 is $21,500.
• Then, figure out what 85% of your Social Security benefits is. 85% multiplied by $12,000 is $10,800.
• Take the smaller of the last two figures. Here, $10,800 is smaller than $21,500, so $10,800 is subject to tax.

As you can see, the calculations get complicated very quickly, but there are ways to get help coming up with precise figures. For instance, this Social Security income tax calculator gives you the ability to fill in your particular income numbers and then tells you how much of your benefit you'll have to include in your taxable income.

What about state income taxes?

As if paying federal income taxes weren't bad enough, some Social Security recipients also have to pay state income tax on their retirement benefits. Fortunately, most states have recognized how much their residents rely on Social Security benefits, and they don't want to chase away retirees by giving them an incentive to relocate to more tax-friendly states after they stop working.

Fully 37 states plus the District of Columbia impose no state or local taxes on Social Security income. The states are:

Some of these states don't impose any income tax at all, so granting an exemption to Social Security income doesn't seem particularly special. However, in the majority of the 37 states above, substantial income taxes apply to most types of income, so it's a significant concession for these state governments to waive their right to tax Social Security.

Meanwhile, quick math will tell you that if 37 states don't tax Social Security, 13 do. Those 13 are the following:

However, the way Social Security benefits are treated for tax purposes varies greatly by state. Four of the states -- Minnesota, North Dakota, Vermont, and West Virginia -- keep things relatively simple, using the same formula that federal income tax law uses to determine the proportion of Social Security benefits that must be added to state taxable income.

Some of these states allow you to exempt a certain amount of your Social Security benefits from state income tax. For example, in Colorado, you can earn a total of up to $24,000 in Social Security benefits and other types of retirement income without paying any state income tax. Only those who earn benefits above that exemption amount would face an added state tax on Social Security. New Mexico has a lower exemption amount of $8,000.

Finally, some states only tax the Social Security benefits of those earning income above a certain threshold. Those amounts vary greatly, ranging from Montana's use of the federal government's $25,000 and $32,000 income limits (for single and joint filers, respectively) to the much more generous limit of $100,000 for joint filers that taxpayers in Rhode Island and Missouri enjoy. Connecticut, Nebraska, and Kansas all have income thresholds somewhere in between, with Connecticut planning to boost its exemption amounts beginning in 2019.

How to minimize -- or avoid -- paying tax on Social Security benefits

The rules governing Social Security benefit taxation focus on income, so coordinating when you start taking Social Security benefits with when you expect to receive other sources of income can make a big difference in whether you have to pay taxes or how much you'll owe. In particular, arranging to have more Social Security income when you don't have income from other sources can help keep more of your Social Security untaxed. The following strategies can make sense in many situations:

• Wait to claim benefits until after you've quit working. Many people claim Social Security benefits at the earliest possible time, even if they're still earning a paycheck. However, the wage income you receive can easily take you over the income thresholds at which your benefits will become taxable, and since you're working, you're more likely to be in a higher tax bracket than you'll be in after you retire. That's a double hit that you can avoid by claiming benefits after you've left the workforce for good.
• Conversely, if you expect your income to rise later in retirement, then it might make sense to claim Social Security earlier. For instance, some early retirees become eligible for private pension payments once they reach a certain age, often somewhere between 65 and 67. If that income will be enough to make your Social Security benefits taxable, then you might do better taking early benefits and enjoying tax-free treatment before your pension income kicks in.
• Those with tax-advantaged retirement savings accounts have some flexibility in deciding when and how to take withdrawals. In particular, if you have both traditional and Roth retirement accounts, you can balance your withdrawals from each to manage your taxable income. Roth withdrawals don't count toward your combined income, so if you take more money from a Roth account, you can take less money from sources that raise your combined income, thereby sheltering more of your benefits from taxation.

The best strategy depends on your individual circumstances, so it's impossible to give one-size-fits-all advice that will work for everyone. But by thinking through your own situation, you can navigate the Social Security taxation rules and cut the amount you have to pay to Uncle Sam.

Be tax-smart with Social Security

It comes as a nasty surprise to many retirees that Social Security benefits can be taxable. But by knowing that in advance, you can manage your affairs in such a way that you'll end up paying as little in federal and state income taxes on your benefits as possible. That'll leave more of your hard-earned benefits to go toward enjoying your retirement years with financial security and peace of mind.