Despite being the most successful and important social program in the U.S., Social Security can come with its fair share of surprises for eligible beneficiaries -- and they aren't always positive. For instance, the newest annual report from the Social Security Board of Trustees projects that the program will begin paying out more than it collects in revenue by 2020, which would be the first time that's happened since 1982.
With each passing year, Social Security's net-cash outflow is forecast to grow, ultimately culminating in the complete exhaustion of its nearly $2.9 trillion in asset reserves by 2035. If no additional revenue is raised or expenditure cuts are made, retired workers could be facing an across-the-board benefit cut of up to 23%.
Surprise! Your Social Security payout may be taxable
However, this surprise still looks to be more than 15 years away. An even more immediate shock could come from the fact that Social Security benefits may be taxable.
In 1983, with the Social Security program in desperate need of an overhaul, the Reagan administration passed a number of bipartisan reforms designed to collect more revenue and reduce long-term expenditures. Among the many amendments that became law was the introduction of the taxation of benefits.
Starting in 1984, any single beneficiary whose modified adjusted gross income (MAGI) plus one-half of benefits exceeds $25,000 (or $32,000 for a married couple filing jointly) could have up to half of their Social Security benefit subject to federal ordinary income tax.
Then, in 1993, the Clinton administration added a second tier of taxation. Using the same formula of MAGI plus one-half of benefits, single recipients above $34,000 and couples filing jointly above $44,000 can have up to 85% of their payout taxed at federal ordinary tax rates.
When the tax was first introduced 35 years ago, it was only designed to impact about 1 in 10 senior households. But because the federal government has never adjusted these income thresholds for inflation, more and more beneficiaries are becoming subjected to this tax. According to The Senior Citizens League, about half of all senior households are now paying at least some tax on their benefits, and this figure is expected to climb in the years that lie ahead.
Will you be subjected to double taxation?
But this isn't all. A quarter of all U.S. states (13 states) also tax Social Security benefits to some varied degree.
Although taxing Social Security benefits at the federal level isn't a form of double taxation -- namely because what you earned in wages and what you receive in benefits isn't the same dollar -- having to potentially pay state-level and federal tax on your Social Security payout is a bona fide form of double taxation.
Among the 13 states that tax Social Security benefits, some are quite generous with income exemptions, meaning few folks are going to wind up owing money. In Missouri, for example, single beneficiaries and couples are allowed to earn up to $85,000 and $100,000, respectively, before any state-level taxation would kick in on Social Security benefits. And even then, there are partial exemptions available. Rhode Island, Connecticut, and Kansas are other taxing states that have very generous income exemptions.
But there are a handful of states that swing in the other direction and have, historically, not been very generous with exemptions. In fact, as recently as a few years ago, four states -- Minnesota, North Dakota, Vermont, and West Virginia -- mirrored the federal tax schedule for Social Security benefits. In essence, the double taxation of Social Security benefits was fairly common in these states.
These "worst taxing states" aren't so bad anymore
But things change, and all four of these previously unfriendly taxing states have reduced beneficiaries' chances of being hit with state-level double taxation on their Social Security benefits.
Minnesota adjusted its taxation of Social Security benefits via the Minnesota Omnibus Tax Bill that was signed into law in May 2017. Although the Gopher State still taxes benefits, certain beneficiaries can subtract between $2,250 and $4,500 from their income, depending on their filing status and MAGI. If taxpayers earn more than certain income thresholds in Minnesota, this maximum subtraction is reduced by 20%.
Beginning in 2018 in Vermont, single filers making less than $45,000 a year and couples filing jointly bringing home under $60,000 are now exempt from state-level Social Security taxes. Vermont begins phasing these breaks out above these income thresholds, with single filers and couples losing any tax breaks at $55,000 and $70,000, respectively.
After more than two months of back-and-forth debates in the West Virginia state legislature, Gov. Jim Justice (R-W.V.) signed a bill into law in March that will phase out Social Security taxation in the Mountaineer State. Although income exemption thresholds of $50,000 and $100,000 do exist for single filers and couples, respectively, residents below these thresholds can expect a 35%, 65%, and 100% elimination of the taxation of Social Security benefits in tax years 2019, 2020, and 2021, respectively.
Even North Dakota has gotten in on the action. A bill signed by Gov. Doug Burgum (R-N.D.) in April allows single filers earning up to $50,000 in federally adjusted gross income and couples filing jointly earning up to $100,000 in federally adjusted gross income to reduce their taxable income by the amount of Social Security benefits that's taxed under federal law.
In short, well-to-do single filers and couples are still likely to be taxed in these four states, but Minnesota, Vermont, West Virginia, and North Dakota are now far more Social Security tax-friendly than they've ever been.