Social Security benefits are earned by paying taxes throughout your entire working life. As a result, you may assume that when you start claiming them, you'll get to keep every dollar and won't owe any taxes on the money.

The assumption that your benefits are tax free may seem even more logical given that the government is paying out this retirement money. Why, you might wonder, does it then turn around to take some of it back? But while it may seem like Social Security retirement income should not be taxed, the fact is that it very well could be. 

In fact, there are two situations in which you could end up seeing your checks shrink because you owe taxes on the benefits.

Older couple looking at laptop in dismay.

Image source: Getty Images.

1. If your income is above federal limits

Retirees across the country could find themselves owing federal taxes on Social Security benefits once their provisional income hits a certain threshold. Provisional income is:

  • All your taxable income.
  • Some of your non-taxable income, such as muni bond interest.
  • Half the amount of your Social Security benefits. 

If your provisional income is between $25,000 and $34,000 as a single tax filer or $32,000 and $44,000 as a married joint filer, up to 50% of your benefits will be taxed at the federal level. And if your provisional income is above $34,000 for single filers or $44,000 for married joint filers, up to 85% of your benefits are taxed. 

Around half of all retirees lose some of their Social Security money to federal taxes. If you expect your income to exceed these thresholds, be prepared to pay the IRS what you owe. If you're a long way from retirement but you anticipate you could earn enough as a senior to be subject to these taxes, you may also want to consider using a Roth IRA for your nest egg. Distributions from it aren't taxable, and they don't count when your provisional income is determined. 

2. If you live in a state that taxes your benefits

It may not be just the federal government that wants a piece of your retirement benefits. If you live in one of these 13 states that tax benefits, you could owe your local government as well:

  • Colorado
  • Connecticut
  • Kansas
  • Minnesota
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • North Dakota
  • Rhode Island
  • Utah
  • Vermont
  • West Virginia

The specific rules about taxing your benefits vary by state, and all states tax only higher earners on their benefits. Some are in the process of phasing out these taxes on retirees. Starting in 2022, for example, West Virginia seniors shouldn't have to worry about owing state taxes on benefits as they are expected to be completely eliminated. 

Still, if you live in one of these states or are considering moving to one in retirement, this could mean keeping less of your Social Security retirement money.

Taxes are never fun to pay, especially so on benefits that you've worked all your life to earn. But knowing these rules will help prepare you for them, or even help you avoid them entirely.