Social Security benefits are a significant source of income for many retirees. Especially if your nest egg isn't as robust as you'd hoped it would be, those monthly Social Security checks can go a long way in helping you enjoy a more comfortable retirement.
However, there's a chance that once you retire, you may not collect as much in benefits as you think. That's partly because the Social Security program is facing a cash shortage and benefits cuts could be looming on the horizon. But your benefits could also be reduced thanks to taxes, and there's a greater chance Uncle Sam will take a cut of your monthly checks in the future.
How Social Security benefits are taxed
Social Security benefits are subject to both state and federal income taxes. Your state taxes depend on where you live, and you could also owe federal taxes if you earn more than a certain limit, which is called your "combined income."
Your combined income includes half your annual Social Security benefit amount plus all other sources of retirement income (excluding Roth IRA withdrawals). So, for example, if you're collecting $20,000 per year from Social Security and are withdrawing $30,000 per year from your 401(k), your combined income is $10,000 plus $30,000, or $40,000 per year.
Whether you'll owe federal income taxes on your benefits (as well as the percentage of your benefits you'll pay taxes on) depends on your combined income:
|Percentage of Your Benefits That Are Taxed||Annual Combined Income (Individuals)||Annual Combined Income (Married Couples 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 to 85%||More than $34,000||More than $44,000|
The good news is that no matter how much you earn, you won't pay taxes on more than 85% of your benefit amount. But to get out of paying federal taxes on your benefits altogether, you'll have to have a combined income of less than $25,000 (or $32,000) per year, which is barely enough for many retirees to survive.
Why more retirees will owe taxes in the future
The combined income limit was established in 1984, when Social Security benefits first became taxable. At that point, only 10% of retirees surpassed the income limit and were required to pay federal income taxes on their benefits, according to a report from the Senior Citizens League.
However, although Social Security benefits are adjusted each year to account for cost-of-living changes, the annual income limit has never been adjusted for inflation. In other words, retirees are seeing their benefits gradually increase due to inflation, but the income limit is staying the same. That, in turn, means more retirees will be subject to income taxes on their benefits.
While only 10% of retirees paid taxes on a portion of their benefits in 1984, that percentage has jumped to 50% in 2019, the Senior Citizens League found. As the general cost of living continues to increase, even more retirees could face taxes on their benefits in the future if the income limit is not adjusted.
What does this mean for future retirees?
It means there's a good chance you'll need to pay income taxes on your benefits, and it's wise to start preparing now. Even if right now your combined income is under the income limit, that could change as your benefits gradually increase after several years of annual cost-of-living adjustments.
As you're planning for retirement, be sure to consider how taxes will affect your benefits -- especially if you expect Social Security to make up a good chunk of your retirement income. A little preparation can go a long way, and by planning for taxes now, they're less likely to take you by surprise in retirement.