Taxes are, unfortunately, a part of life, and it's hard to escape them even in retirement.
Your Social Security benefits may be subject to both state and federal income taxes, which can take a substantial bite out of your monthly payments.
While it may be tough to avoid taxes, if you're expecting to depend on your benefits in retirement, it pays to understand how they'll affect your income. And there's one sneaky tax rule that could shrink your future benefits. Here's what you need to know.
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How taxes will affect your Social Security
Whether or not you're subject to state taxes will depend on where you live, and fortunately, there are 38 states that don't tax Social Security benefits. So there's a good chance you're already off the hook for state taxes.
Federal taxes, though, will depend on a figure called your provisional income. This is half of your annual benefit amount plus your adjusted gross income and any nontaxable interest. So, for instance, if you're collecting $20,000 per year from Social Security and withdrawing $40,000 per year from your 401(k), your provisional income would be $50,000 per year.
Here's how much of your benefits could be subject to taxes depending on your provisional income:
| Percentage of Your Benefits Subject to Federal Taxes | Provisional Income (Individuals) | Provisional Income (Married Couples) |
|---|---|---|
| 0% | Under $25,000 per year | Under $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 |
Data source: Social Security Administration.
The bad news is that you can only avoid federal taxes if your provisional income falls below $25,000 per year (or $32,000 per year for married couples filing jointly). But the good news is that no matter how much you're earning, you won't pay taxes on more than 85% of your benefit amount.
Your benefits could face steeper taxes in the future
If these income limits seem low, it's because they are. These numbers haven't been adjusted since 1984, when Social Security first became subject to federal taxes.
For reference, $34,000 in 1984 would be the equivalent of more than $99,000 in 2022 dollars, and $44,000 would equate to around $128,000 in modern times.
In 1984, only around 10% of beneficiaries were subject to federal taxes, according to nonprofit group The Senior Citizens League. But a 2015 report from the Social Security Administration projected that around 56% of seniors will pay federal taxes on their benefits by 2050 (and that number could be even higher due to surging inflation in recent years).
If these income limits remain unchanged, more retirees will be subject to federal taxes in the future (and those who are already paying federal taxes may need to pay more) as the general cost of living increases.
A loophole to reduce federal taxes
It's tough to avoid Uncle Sam, but there is one way to reduce or even eliminate federal taxes on your benefits: Invest in a Roth account.
With a Roth IRA or Roth 401(k), you'll pay income taxes on your initial contributions, but your withdrawals are tax-free. Also, withdrawals from these accounts do not count toward your provisional income -- which could potentially reduce it enough to avoid taxes altogether.
For example, say you're receiving $20,000 per year from Social Security and are withdrawing $40,000 per year from a traditional IRA. In this scenario, your provisional income would be $50,000 per year, and you'd owe federal taxes on up to 85% of your benefit amount.
However, say that instead of withdrawing that $40,000 per year from a traditional IRA, you pull it from a Roth IRA. In that case, because that $40,000 doesn't count toward your calculations, your provisional income would be just $10,000 per year -- and you wouldn't owe federal taxes at all.
Social Security taxes can be confusing, but it's worthwhile to at least understand the basics. When you know how federal taxes will affect your future payments, it will be easier to plan and budget accordingly.
