Saving for retirement is tough, and Social Security benefits can go a long way toward bridging the gap between what you have saved and what you need to enjoy your senior years comfortably.
However, there is a sneaky expense that could take a bite out of your Social Security benefits. And if you live in one of 12 states, you might not receive as much as you expect each month.
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How taxes affect your Social Security
Even after you retire, you might still owe a portion of your income to Uncle Sam. Not only are 401(k) and traditional IRA withdrawals subject to income taxes, but Social Security benefits are as well.
There are two types of taxes you might owe on your benefits: state and federal. Your state taxes will depend on where you live, and the good news is that the majority of states do not tax Social Security benefits. The states that do tax your monthly payments are:
| Colorado | Connecticut | Kansas | Minnesota |
| Missouri | Montana | Nebraska | New Mexico |
| Rhode Island | Utah | Vermont | West Virginia |
If you live in a state that does not tax Social Security, you're not off the hook yet. No matter where you live, you could still owe federal taxes on your benefits.
Your federal taxes will depend on a figure called your combined income. This is half of your annual benefit plus your adjusted gross income. So, for instance, if you're receiving $20,000 per year from Social Security and are withdrawing $30,000 per year from your 401(k), your combined income would be $10,000 plus $30,000, or $40,000.
Here's how much of your benefits could be subject to federal taxes depending on your combined income:
| Percentage of Your Benefits Subject to Federal Taxes | Combined Income for Individuals | Combined Income for Married Couples Filing Jointly |
|---|---|---|
| 0% | Less than $25,000 per year | Less than $32,000 per year |
| Up to 50% | $25,000 to $34,000 per year | $32,000 to $44,000 per year |
| Up to 85% | More than $34,000 per year | More than $44,000 per year |
Source: Social Security Administration
The good news is that it is possible to avoid federal taxes entirely. But because the income limits are so low, you'll need a combined income of under $25,000 per year (or $32,000 per year if you're married) to get out of paying federal taxes on your benefits.
How to reduce your taxes in retirement
In many cases, taxes are an unavoidable expense that workers will simply need to plan for in retirement. But there is one trick that can potentially reduce your taxes: investing in a Roth IRA.
Roth IRA withdrawals are already exempt from income taxes, but this type of account can also help you get out of taxes on your Social Security benefits. Withdrawals from a Roth IRA do not count toward your combined income. So if the majority of your income comes from a Roth account, you can potentially get out of federal taxes altogether.
For example, if you have an annual Social Security benefit of $20,000 and you're withdrawing $30,000 per year from a 401(k), your combined income is $40,000 per year -- which means up to 85% of your benefits will be subject to federal taxes.
On the other hand, say you're still receiving $20,000 per year from Social Security but you're withdrawing $30,000 per year from a Roth IRA rather than a 401(k). In this scenario, your combined income is just $10,000 per year, and 0% of your benefits are subject to federal taxes.
Maximizing your Social Security benefits
Not everyone will be able to contribute to a Roth IRA, and that's OK. If all your retirement savings are in another type of account or if you're earning matching contributions through a 401(k), you might be better off staying with whatever retirement account you have. But it's never a bad idea to know your options.
Taxes are a fact of life for most people, so it's wise to start preparing for them now. By understanding which taxes you could owe and factoring them into your budget, you can avoid any Social Security surprises in retirement.
