Even though you've been paying Social Security taxes for decades, you may not be able to escape Uncle Sam even after you claim benefits in retirement.
It's important to understand how taxes will affect your benefits, because for many people Social Security is a significant source of retirement income. In fact, roughly half of baby boomers say their benefits will be their primary source of income once they retire, according to a survey from American Advisors Group. If you're depending on those checks to make ends meet, it may be more difficult to make it through retirement with taxes taking a chunk of your earnings each month.
Each state has its own rules about whether Social Security benefits are taxed, and if so how much. The good news is that there are 37 states where you won't need to pay state taxes on your benefits. Here's the complete list:
Alabama, Alaska, Arizona, Arkansas, California, Delaware, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, Nevada, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, South Dakota, Tennessee, Texas, Virginia, Washington, Washington, D.C., Wisconsin, and Wyoming.
However, even if you live in one of these states, you're not off the hook just yet -- depending on your income, you may still have to pay federal taxes on your benefits.
How to determine whether you'll pay federal taxes on benefits
The Social Security Administration uses what's called your "combined income" to determine whether you'll owe federal taxes on your benefits. Your combined income is calculated by adding half your annual benefit amount plus all the other income you receive for the year. For example, if you're receiving $20,000 per year in benefits and also withdraw an additional $30,000 from your retirement fund, your combined income is $40,000.
Here's how much of your benefits you may owe taxes on depending on your combined income:
|Percentage of Your Benefits That Are Taxed||Annual Combined Income for Those Filing Taxes as an Individual||Annual Combined Income for Those Married Filing Jointly|
|0%||Less than $25,000||Less than $32,000|
|Up to 50%||$25,000 to $34,000||$32,000 to $44,000|
|Up tp 85%||More than $34,000||More than $44,000|
No matter how much you're earning each year, you won't pay taxes on more than 85% of your benefits. And if you're earning less than $25,000 per year (or $32,000 for married couples), you won't need to worry about paying federal taxes at all.
That means that if you're living in a state that doesn't tax benefits and you're earning less than the annual income limit, you may be able to avoid Social Security taxes altogether. Although it's tough to survive on less than $25,000 (or $32,000) per year, not having to pay taxes on your benefits is good news for those who don't have much in savings and are trying to squeeze every dollar they can out of Social Security.
Is it worth it to move to minimize taxes?
If you live in a state that does tax Social Security benefits, should you consider moving to receive the tax break? It depends on a few factors.
Primarily, how does the overall cost of living in your prospective new state compare to that of your current state? If you're saving money on taxes but paying more in every other area of your budget, you're probably not coming out ahead financially by moving. But if your new state has an overall lower cost of living and you'd also be able to avoid state taxes on benefits, it might be a smart move.
Before you start packing your bags, though, figure out exactly how much you'll save in taxes by moving. Of the states that do tax benefits, each one has slightly different laws regarding how much you'll pay -- so check your state's Department of Revenue website for more information about what you can expect to pay. Also, if you haven't done so already, create a mySocialSecurity account to see roughly how much you will be receiving in Social Security benefits based on your real earnings. Once you know what your future checks will look like and how much you'll likely pay in taxes, you can get a better idea of how much you'll owe. If it's a significant amount of money, it might be worthwhile to move. Otherwise, you may be better off avoiding the hassles and expenses of moving by staying put.
Also, if you're stuck paying taxes on your benefits and don't want to move, there are ways to increase your benefits to take the sting out of tax time. For example, if you wait until beyond your full retirement age (which is age 66, 67, or somewhere in between, depending on the year you were born) to claim, you'll receive extra money on top of your full benefit amount. For those with a full retirement age of 67, waiting until age 70 can result in a 24% bonus each month. While you may still need to pay taxes on that money, the extra cash can make it a little easier to make ends meet.
Paying taxes can take the wind out of your sails in retirement, especially if you weren't expecting to have to pay them. But you may be able to avoid them -- or at least lower them as much as you can -- depending on where you live. And the more you know about what to expect in retirement, the more prepared you'll be.