There's no question that this has been a challenging year for all Americans. The coronavirus disease 2019 (COVID-19) pandemic has completely upended societal norms, driven more than 20 million people out of work, and caused a level of panic and uncertainty that hasn't been seen in a really long time.
But amid the chaos, the nation's most storied social program, Social Security, continues to be a rock for nearly 65 million Americans, many of whom are senior citizens. The Social Security program has navigated its way through 13 previous recessions with flying colors and will certainly make it through the COVID-19 crisis, as well.
However, being the most successful social program doesn't mean everyone necessarily has the pertinent facts about Social Security. A number of common misconceptions have prevailed for decades, such as the (incorrect) idea that Social Security would be bankrupt by the time future generations of workers retire or that Congress has dipped its hands into Social Security's proverbial cookie jar and pilfered funds from hardworking Americans.
There is, however, one Social Security claim that has merit as both fact and fiction -- the idea that Social Security benefits can be taxed twice.
Are you being doubled taxed on your Social Security benefits?
The idea goes that hardworking Americans pay into the Social Security system via the payroll tax prior to retirement, then during retirement, they can be hit with a federal tax on the Social Security benefits they receive.
For context, the taxation of Social Security benefits becomes applicable when the modified adjusted gross income (MAGI) for an individual or couple filing jointly, plus one-half of benefits received, surpasses $25,000 or $32,000, respectively. This initial tier exposes up to half of a beneficiary's Social Security benefits to federal ordinary income tax rates.
A second tier exists for individuals and couples with a MAGI plus one-half of benefits above $34,000 and $44,000, respectively, where up to 85% of Social Security benefits can be taxed. The income thresholds in these two tiers have never been adjusted for inflation, despite being signed into law in 1983 (the lower tier) and 1993 (the higher tier).
According to nonpartisan senior-focused group The Senior Citizens League, around half of all senior households are exposed to taxation on their Social Security benefits each year -- and this figure is growing due to the income thresholds not being adjusted for inflation in decades.
Seems like a pretty cut-and-dried case of double taxation, right? Well, it's not.
To begin with, not everyone faces federal taxation during retirement. Although half of all senior households are currently footing some form of tax bill each year on their benefits received, the other half won't owe a cent.
What's more, the idea of double taxation is dependent on the idea that the money Social Security is collecting each year is recurring in nature. Though the 12.4% payroll tax on earned income and the taxation of benefits are recurring, the $80.8 billion collected in 2019 as interest income on the program's $2.9 trillion in asset reserves isn't recurring. In laymen's terms, you're not being taxed on the same dollar you paid into the system, with close to 8% of the program's annual income derived from interest paid by the government.
In these respects, the double taxation of Social Security benefits is considered a myth.
In these 13 states, the double taxation of Social Security benefits can become a reality
As I stated earlier, there is some fact to the idea that Social Security benefits can be double taxed. This misconception becomes reality if you happen to live in one of the 13 states that also tax Social Security income to some varied degree. These states are (in alphabetical order):
- New Mexico
- North Dakota
- Rhode Island
- West Virginia
If a Social Security recipient earns enough that they're taxed at the state level, they'll also be subjected to federal taxation in these 13 states. That's the same dollar being hit with two separate income taxes, which is the precise definition of double taxation.
Then again, the taxation of benefits at the state level can vary wildly. As an example, despite being a taxing state, Missouri offers some fairly generous exemptions to Social Security beneficiaries. The taxation of benefits doesn't kick in until $85,000 for single filers and $100,000 for couples filing jointly. Similar generous exemptions can be found in Rhode Island, Connecticut, and even Kansas.
At the other end of the spectrum are states like Minnesota, North Dakota, Vermont, and West Virginia. As recently as a couple of years ago, all four of these states mirrored the federal tax schedule for Social Security benefits. However, all four have since updated their income thresholds and become far more lenient on taxing Social Security income. Still, there's a far greater likelihood of being double-taxed in these four states than in Missouri, for instance.
Ultimately, the reality of Social Security double taxation depends on how much you earn and where you live.