Social Security can aptly be described as our nation's most important social program. Aside from providing a guaranteed payout to more than 62 million beneficiaries each month, 22.1 million of which are being kept out of poverty as the result of their benefit check, the program also covers some 175 million workers in the event of an untimely disability or death. Though not an entitlement, most Americans will receive protections and/or a benefit from Social Security during their lifetime.
Yet what may or may not come as a surprise is that basic knowledge surrounding Social Security is often lacking. Even with many retirees leaning on Social Security as a primary income source, a number of aspects of the program can take folks by surprise. Arguably topping the list is that Social Security benefits may be taxable.
Chances are you'll owe tax on your Social Security benefits
Back in 1983, with the Social Security program facing the complete exhaustion of its asset reserves by the end of the year, the Reagan administration passed the Amendments of 1983. This last major overhaul of the program introduced a gradual increase to the full retirement age from 65 to 67 over a four-decade period, as well as implemented the taxation of Social Security benefits, which began in 1984. The purpose of these changes was to reduce lifetime benefit payouts to future generations in order to save the program money in the case of the full retirement age increase, and to generate additional revenue with the taxation of benefits.
When it was introduced, the taxation of benefits was only expected to affect about one in every 10 senior households. That's because it only applied to single taxpayers whose adjusted gross income (AGI) plus one-half of their benefits surpassed $25,000. For couples filing jointly, this figure was $32,000. If beneficiaries surpassed these thresholds, up to half of their benefits could be taxed at the federal ordinary income tax rate.
However, things have changed a bit since 1983. In 1993, the Clinton administration passed a second tier of taxation that allowed up to 85% of benefits to be taxed at the federal level if a single taxpayer surpassed $34,000 in AGI plus one half of benefits, or $44,000 for a couple filing jointly.
What's more, none of these income thresholds have ever been updated to account for inflation. Thus, what was once a tax that affected just one in 10 senior households now affects 56% of them, according to The Senior Citizens League. This means you have a better chance than not of owing tax to the federal government on your Social Security benefits when you retire.
These 13 states tax Social Security benefits, too
But that's not all. In addition to federal taxation, there are 13 states that tax Social Security benefits to some varied degree.
On one hand, this means that three-quarters of all states are completely tax-free when it comes to Social Security benefits. If you live in one of these 37 states, then you only have to worry about the possibility of federal taxation if you cross the aforementioned income thresholds.
On the other hand, if you do live in one of the 13 taxing states, you could fall subject to double taxation -- and that stinks! The 13 states that currently tax benefits are (in alphabetical order):
- New Mexico
- North Dakota
- Rhode Island
- West Virginia
Some of these states, such as Minnesota, North Dakota, Vermont, and West Virginia, mirror the federal schedule, while others, such as Utah and New Mexico, offers forms of retirement credits or deductions.
Four of these states are not like the others
However, four of these taxing states aren't anything like their peers. In particular, their AGI exemption thresholds are higher than the median household incomes within their respective states, meaning more than half of all residents will be exempt from having their benefits taxed. These four states are:
- Missouri: The state of Missouri has the friendliest income exemptions of the 13 taxing states. Single and married filers can earn up to $85,000 and $100,000 in respective AGI without paying a cent in tax on their Social Security benefits to the state. Comparatively, the American Community Survey (ACS) from the U.S. Census in 2017 pegs median household income in the state at just $53,578. This suggests that few Social Security beneficiaries are owing anything to the state.
- Rhode Island: The state of Rhode Island may be small, but it has a pretty big heart when it comes to exemptions, with single and married recipients allowed to earn up to $80,000 and $100,000 in respective AGI before benefits would be taxed. By comparison, the ACS in 2017 found the state's median household income to be $63,870. Translation: This tax impacts very few Social Security recipients.
- Kansas: The state of Kansas is another hidden gem on the tax front, with an exemption for folks earning up to $75,000 in AGI. Based on ACS data from 2017, median household income was $56,422 in the state, suggesting that more residents than not won't face the taxation of Social Security benefits.
- Connecticut: Lastly, I'm going to lump Connecticut in there, despite the fact that it has one of the highest median household incomes in the country at $74,168 in 2017. Beginning in 2019, the AGI exemption levels in Connecticut are rising from $50,000 and $60,000 for single filers and couples filing jointly, to $75,000 and $100,000, respectively. This should allow more than half of all beneficiaries to escape taxation.
In essence, only beneficiaries in the nine remaining taxing states really need to think about the possibility of double taxation.