You pay into Social Security your entire working life with the understanding that when you reach retirement age, you can cash in on these benefits. But what you might not realize, is that some of that money will go back to the government in yearly taxes, depending on your income and marital status.

There are ways to avoid being taxed on your benefits, but it's tricky. You first need to understand how taxes on this benefit are calculated. Below, I'll break it down to show you how to avoid losing your Social Security benefits to Uncle Sam.

Confused man staring at blackboard with calculations.

Image source: Getty Images.

How Social Security benefits are taxed

Here are the rules regarding taxes on Social Security benefits, per the Social Security Administration (SSA):

  • If you file a tax return as Single, Head of Household, or a Widow(er) and your combined income is:
    • between $25,000 and $34,000, then you may be taxed on up to 50% of your benefits.
    • greater than $34,000, then you may be taxed on up to 85% of your benefits.
  • If you file a tax return as Married Filing Jointly and your combined income is:
    • between $32,000 and $44,000, then you may be taxed on up to 50% of your benefits.
    • greater than $44,000, then you may be taxed on up to 85% of your benefits.

To begin, we must define what the SSA means by "combined income." Combined income equals your adjusted pre-tax income for the year plus nontaxable interest plus half of your Social Security benefits. 

Your adjustable gross income is the amount of money you, and your spouse if you are filing jointly, earned this year from wages, dividends on investments, pensions, and any other income sources other than Social Security. If you have any municipal bonds in your investment portfolio, then you'll probably also have nontaxable interest. Certain savings bonds may be tax-exempt, as well.

Finding what half of your annual Social Security benefit is simple. If you don't know how much in benefits you've received, create an online my Social Security account.

You should now have three figures to add together in order to find your level of taxability as determined by your 'combined income': adjusted gross income, nontaxable interest and half of your Social Security benefits.

Here's a quick example: Your adjusted gross income is $30,000 and you have $4,000 in nontaxable interest, and you received $10,000 in Social Security benefits this year, then you would add $30,000 + $4,000 + $5,000, for a combined income of $39,000.

From there, things get slightly more complicated. Just because you can be taxed on up to 50% or 85% of your Social Security benefits doesn't mean you will be. The government says that you are to be taxed on the lesser of half of your Social Security benefits or half of the difference between your combined income and the lower range given by the SSA in the rules listed above.

If your combined income is above the lower taxation threshold ($25,000 for single adults and $32,000 for married couples), find the difference between your income and that lower threshold and then divide it in half, to find the amount that you'll pay taxes on. To calculate the tax rate that applies to that taxable amount, perform the additional calculations shown in this IRS worksheet.

Put into practice

To give you some idea of how this works, let's assume you're an individual with an adjusted gross income of $25,000 this year, either from work, retirement savings, or both. You have $1,000 in nontaxable interest and you received $12,000 from Social Security this year. You would add your $25,000 income, the $1,000 nontaxable interest, and half of the Social Security benefits, or $6,000, to equate a combined income of $32,000.

This falls within the 50% taxation range, but that doesn't mean you will be taxed on the full $6,000 you received in Social Security benefits. Why? It's a tricky rule, but the IRS says that you are to be taxed on the lesser of half of your Social Security benefits or half of the difference between your combined income and the base amount determined by the SSA, $32,000 in this example.

Your $32,000 combined income is $7,000 above the base amount of $32,000, so you would divide this $7,000 in half and end up with $3,500. Because $3,500 is less than half of your Social Security benefits ($6,000), you would pay this amount instead.

But what happens if your combined income is much higher? Let's take the same example, but bump the adjusted gross income up to $45,000. Add the $1,000 nontaxable interest and half of the Social Security benefits, for a combined income of $51,000.

This puts you squarely in the 85% taxation range. Calculating your Social Security benefit taxes are a little trickier in this situation, but the principles are the same. You will pay the lesser of 85% of your Social Security benefits or the amount you calculate using the following formula.

Per the IRS worksheet, you first subtract the 50% taxation threshold, in this case $25,000, from the 85% taxation threshold, $34,000, to get a difference of $9,000. Then, you divide this number by two to get $4,500. Next, subtract your combined income from the 85% taxation threshold ($34,000 in this example). That leaves us with $17,000 ($51,000-$34,000 = $17,000). Multiply that number by 85% to get $14,450. Then, add the $14,450 to the $4,500 we calculated above to get your total amount. In this example, it is $18,950.

Next, calculate 85% of your Social Security benefits by multiplying 85% by the full amount of Social Security you received this year, $12,000 in our example. The final number is $10,200 and because $10,200 is lower than the $18,950 that we calculated above, you would be taxed on $10,200 of your Social Security benefits.

States can also tax your benefits

The calculations above are for federal taxes, but state governments can also impose taxes on your benefits. The below states have taxes on Social Secuity: 

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

Unfortunately, there isn't a simple formula to calculate your state taxes because each state handles them differently. Some states use a formula similar to that of the federal government, while others only tax your benefits if your income is over a certain threshold. If your state is one of the 13 that tax Social Security benefits, reach out to your state's Department of Revenue to find out how to calculate the amount you'll owe.

Avoid being taxed on your Social Security benefits

You may not be able to avoid being taxed on your Social Security benefits entirely, but there are a few things you can do to minimize the likelihood of paying back your benefits. It's all about lowering your combined income so you aren't at risk of being taxed in the first place.

One of the easiest ways to do this is to delay taking Social Security until you've fully retired and are no longer collecting wages. Otherwise, the combination of your Social Security benefits and your income may very well push you over the Social Security taxation threshold.

If you're fully retired and you find you're still at risk of having your benefits taxed, you could reduce the amount you withdraw annually from your retirement accounts to keep your combined income low. Of course, doing so may limit your standard of living so be careful to budget closely if you take this route. Alternatively, you could withdraw most of your income from your Roth accounts. This money has already been taxed, so it doesn't count toward your combined income.

Even if you can't avoid being taxed on your benefits by changing your working situation, delaying Social Security benefits or reducing your withdrawals from retirement accounts, it pays to understand how much you're going to be taxed. No one wants to receive an unpleasant surprise when filing a tax return, so use the calculations above to get started.

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