Social Security is easily our nation's most important social program. Each and every month, approximately 63 million people receive a benefit check from the Social Security Administration, and more than 22 million of these folks will count on this check to lift them out of poverty. No other social program has such an incredible impact on the financial well-being of so many people.
But it's also a program that relies on copious amounts of funding to meet the financial needs of its recipients. This means there are a handful of ways that taxes associated with the Social Security program can impact you, whether you realize it or not. Here are the three types of Social Security taxation you should familiar yourself with.
1. The 12.4% payroll tax on earned income
The most commonly felt impact of Social Security taxation is the 12.4% payroll tax on earned income, which is one component of Federal Insurance Contribution Act (FICA) taxes. FICA tax is 15.3% overall (or 16.2%, just for employee wages over $200,000), and it includes Social Security's payroll tax and the Medicare tax.
Put simply, the payroll tax gobbles up 12.4% of all earned income between $0.01 and $132,900, as of 2019. By "earned income," I mean wages and salary, with investment income being exempted from the payroll tax. Since more than nine out of 10 workers will earn less than $132,900 this year, it means most folks are paying into the Social Security program on every dollar they earn. Meanwhile, earned income above $132,900 is exempted from the payroll tax, with an estimated $1.2 trillion in earnings escaping taxation in 2016, up from around $300 billion in 1983.
The $132,900 earnings cap is tied to the National Average Wage Index (NAWI). As long as there's a positive cost-of-living adjustment (COLA) passed along to beneficiaries in a given year, the earnings tax cap increases on par with the percentage increase in the NAWI, rounded to the nearest 0.1%. In the rare event that deflation occurs and COLA is negative, the earnings cap remains static from one year to the next, but eventually plays catch-up once COLA becomes positive again.
Perhaps the most important thing to recognize is that not everyone is paying 12.4% on their earned income. If you're self-employed, then you are paying the full amount. But if you're working for someone else or a company, your employer is responsible for covering half of your payroll tax liability (6.2%). The other half (6.2%) falls on your shoulders and is automatically taken out of each paycheck.
In 2017, the payroll tax generated $873.6 billion in revenue for Social Security, or close to 88% of the money the program collected.
2. The federal taxation of benefits
Beyond just paying into the system during your working years, you may also be taxed once you begin taking benefits. In 1984 (following passage of the Amendments of 1983), the federal government introduced the federal taxation of Social Security benefits for select individuals and couples.
Initially, federal ordinary income tax rates were applied on up to 50% of an individual's or couple's benefits if they crossed certain income thresholds. If a single beneficiary's modified adjusted gross income (MAGI) plus one-half of benefits surpassed $25,000, or a couple's MAGI plus one-half of benefits topped $32,000, the taxation of Social Security benefits applied. When first implemented, it was expected to impact about one in 10 senior households.
Then, in 1993, the Clinton administration added a second tier of federal taxation on Social Security benefits. If a single beneficiary topped $34,000 (using the same MAGI plus one-half benefits formula), or a couple receiving benefits surpassed $44,000, up to 85% of Social Security benefits could be subject to federal taxation.
Arguably the biggest issue with the taxation of benefits is that the income thresholds haven't been adjusted for inflation once since they were introduced. According to The Senior Citizens League, it's led to 51% of senior households paying tax on their benefits today, with this figure expected to climb as time passes.
In 2017, the taxation of benefits brought in almost $38 billion, but it's expected to play a bigger role over the next decade. The latest Social Security Board of Trustees report forecasts that $561.2 billion is expected to be generated from this tax between 2018 and 2027.
3. State-level taxation of benefits
Lastly, but not to be overlooked, 13 states also tax Social Security benefits to some varying degree. It should be pointed out, though, that state-level tax revenue does not work its way back into the program, but is rather used by these taxing states to help fund their budgets.
Listed alphabetically, the 13 states that tax Social Security benefits are: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia. If you live in one of the 37 states not listed here, then there's no "third way" that Social Security taxation can affect you.
Now, understand that the level of taxation you could face on your benefits, and the income exemption levels, vary by state. For instance, Missouri, Rhode Island, Connecticut, and Kansas are exceptionally generous with income exemptions. Single beneficiaries can earn up to $85,000, $80,000, $75,000, and $75,000, respectively, before any possibility of being taxed on their payout. And even then some of these states offer credits that can reduce or eliminate liability for seniors.
On the other end of the spectrum, states like North Dakota, Vermont, and West Virginia mirror the federal tax schedule for Social Security benefits. This means if you've surpassed the income thresholds to be partially taxed on your benefits at the federal level, then you can count on double taxation at the state level.