Social Security plays a vital role in the financial well-being of tens of millions of Americans, and many more anticipate taking advantage of it once they retire. But many recipients get a big surprise after they start receiving their monthly checks, because the federal government in some cases treats Social Security as taxable income and charges income tax on it.

One reason so few people know about Social Security benefit taxation is that it's gradually crept up on retirees over the years. When the tax laws that started taxing benefits first came into effect, they applied to only a handful of taxpayers. Now, though, the number of people having to pay taxes on at least part of their Social Security income is approaching 21 million, and with hundreds of billions of dollars getting taxed, the financial impact on the elderly is substantial. Perhaps most alarming is the fact that almost half of all reported Social Security benefits end up getting included in taxable income -- and that percentage is gradually rising over time.

Why did Social Security benefits ever get taxed in the first place?

Most Americans are appalled to learn that their benefits could ever be subject to tax. After all, it's payroll tax taken out of workers' paychecks throughout their careers that goes toward funding the benefits that Social Security pays out. So it's reasonable to think that having paid one round of tax, you wouldn't have to deal with the IRS trying to take a second bite at the apple.

Wall with engraved plaque reading Internal Revenue Service.

Image source: Getty Images.

But the taxation rules came about as part of an attempt to shore up Social Security's finances in the early 1980s. They imposed a tax on up to half of all benefits for single filers with incomes of $25,000 or more, and joint filers with income of $32,000 or more. Income for these purposes was defined as half of Social Security benefits plus all of most other sources of income, including wages, investment income, retiree pensions, and taxable retirement account withdrawals. Later on, a second set of thresholds at $34,000 for singles and $44,000 for joint filers allowed the IRS to force taxpayers to include up to 85% of benefits in their taxable income.

How income creep has forced more Social Security recipients to pay tax

One key reason more people than ever are paying taxes on their benefits is that those income thresholds above have no built-in adjustment for inflation. As incomes rise, therefore, more people end up subject to the tax.

As of 2017, the most recent year for which the IRS has released data, more than 20.9 million taxpayers had to pay taxes on some portion of their benefits, up by about 1.2 million in just the past couple of years. When you take the $309.5 billion in taxable benefits and divide it by the roughly $645 billion in total benefits reported on 1040 tax returns, you'll see that almost 48% of Social Security benefits are subject to tax. That number is also up significantly in recent years.

What you can do

Admittedly, the news might not be as bad as it sounds. Most retirees are in relatively low tax brackets, so even if they have to include a portion of their Social Security as taxable income, it won't necessarily translate into a big tax bill. But with many retirees living on fixed incomes, losing any of their benefits to the IRS is a potential problem.

Unfortunately, once you start receiving benefits, there aren't that many things you can do to affect how much of them will get taxed. You might be able to manage how much money you withdraw from retirement accounts, especially if you have any savings in Roth IRAs. Roth distributions aren't counted as income for purposes of Social Security taxation.

The better choice is to think about what affect Social Security income taxation will have before you claim benefits. In particular, many people find that claiming early benefits while they're still working is most likely to lead to adverse tax consequences. Waiting to claim until later can save you on your taxes.

Knowing that some of your Social Security could be subject to income tax is important. That way, you'll be more likely to make the best possible decision about when to claim -- and be prepared for any tax bill that results.