It's perhaps the most hated aspect of Social Security: The taxation of benefits.
Signed into law in 1983 by the Reagan administration, and officially implemented in 1984, the taxation of benefits allowed the federal government to tax a portion of individual's and couple's Social Security income if they exceeded certain thresholds. For single taxpayers, if modified adjusted gross income (MAGI), plus one-half of benefits, topped $25,000, federal taxation could be applied on up to 50% of benefits paid. For couples filing jointly, the earning threshold was $32,000. When introduced, this tax was designed to impact about 1 in 10 senior households.
Then, in 1993, the Clinton administration added a second tier to the taxation of benefits. This new tier allowed up to 85% of a person's or couple's benefits to be taxed at the federal ordinary income rate if exceeding certain thresholds. Using the same MAGI plus one-half benefits formula from above, these caps are $34,000 for single tax filers and $44,000 for couples filing jointly.
Here's why most people loathe the taxation of Social Security benefits
Why the American public takes exception with the taxation of benefits is twofold.
First, it feels like a form of double taxation to some folks. In other words, they've paid into Social Security via the payroll tax on their earned income (wages and salary), and now they're paying tax on their benefits, which makes it appear as if the federal government is dipping its hands into the cookie jar twice. However, this isn't the true definition of double taxation, since not all income from Social Security is derived from taxation, nor are you receiving back the same dollar that was taxed when you were generating wage or salary income.
A second reason the taxation of benefits is despised is because these noted earning thresholds have never been adjusted for inflation. Instead of affecting 10% to 20% of seniors, roughly half of all retired workers now owe some form of tax on their benefits to Uncle Sam. And don't think for a moment that the federal government is incented to update these thresholds for inflation. Every dollar generated by the taxation of benefits is sorely needed to maintain the buoyancy of the Social Security program.
Despite taxing Social Security benefits, you probably won't owe anything in these four states
However, the taxation of benefits at the federal level tells only part of the story. There are 13 states that also tax Social Security benefits to some varied degree. This means that if you live in one of the 13 states, you genuinely could face a form of double taxation.
But not all states tax benefits equally. Whereas a small number of states mirror the federal tax schedule, such as Vermont and West Virginia, a number of others impose lofty income-exemption limits that'll ensure few seniors actually owe any Social Security tax at the state level. Here are four such states where you may not owe a dime in state-level tax on your benefits.
Even though taxing states usually get a bad rap, the Show-Me State has the highest income exemptions around for individual taxpayers. Single filers can have an adjusted gross income (AGI) of up to $85,000 without paying a cent in state-level tax on their Social Security benefits, with couples allowed an AGI of up to $100,000. But even if you cross above these earning thresholds, Missouri may still offer partial exemptions. Since few seniors are likely to earn more than $85,000 a year, or over $100,000 a year as a couple filing jointly, most won't pay state-level tax on their benefits in Missouri.
Though the smallest state in the U.S., Rhode Island packs a big punch on the income exemption front, even though it's one of 13 states that taxes Social Security benefits. Last year, individuals and couples filing jointly were allowed to earn up to $83,550 and $104,450 in AGI, respectively, before they owed any state-level tax on their benefits. You'll note, the threshold for couples is higher in Rhode Island than any other taxing state. These limits also adjust upward each year to account for inflation, which is something the federal government's taxable earning thresholds don't do.
The Nutmeg State has traditionally been in the middle tier of income exemptions among the 13 taxing states. But that changed in 2017, which is when legislation was passed that would significantly increase the state's income thresholds tied to Social Security benefit taxation in 2019. Last year, single filers and couples filing jointly could earn up to $50,000 and $60,000 in AGI, respectively, without being subject to Connecticut's tax on benefits. However, in 2019, these same residents can earn up to $75,000 and $100,000 in AGI, respectively, before state-level taxation kicks in.
Last, but not least, the Sunflower State offers relatively generous income exemptions for single taxpayers, with those exemptions not being as robust for couples filing jointly. Kansas sets the income exemption bar at $75,000 in AGI, regardless of filing status. This is going to allow single seniors the ability to earn up to $75,000 in AGI each year without paying a penny in state-level Social Security taxes. Of course, when you have potentially two incomes involved, such as couples filing jointly, a $75,000 AGI exemption isn't as robust as the other states listed above.
As one last reminder: Even though most seniors won't owe tax on their Social Security benefits in Missouri, Rhode Island, Connecticut, and Kansas, they may still be liable at the federal level.