It's a common misconception that Social Security is tax-free income. While this is certainly true for some people, the reality is that many retirees pay income tax on their Social Security benefits to one extent or another.
However, there's quite a bit to unpack about Social Security taxes. With that in mind, here are three things retirees should know about income taxes on their Social Security benefits.
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1. No retiree pays tax on 100% of their Social Security benefits
To determine whether your Social Security benefits are taxable, the IRS looks at a figure called your combined income. This includes your adjusted gross income plus half of your Social Security benefits, as well as any nontaxable interest you receive (from tax-free bonds, for example).
- If your combined income is below $25,000 ($34,000 if you file a joint return), you won't pay a penny of tax on your Social Security benefits.
- If your combined income is between $25,000 and $34,000 ($32,000 and $44,000 for joint filers), as much as 50% of your Social Security benefits are taxable.
- If your combined income is above $34,000 for single filers or $44,000 for joint filers, as much as 85% of your Social Security benefits may be taxable.
There are two key takeaways here. First, nobody pays tax on 100% of their Social Security income -- at most, 85% can be included in your taxable income. Second, if Social Security makes up the bulk of your retirement income, your combined income is likely to fall below the threshold where it is taxable at all.
2. Some states have their own Social Security income taxes
The good news is that most states don't tax Social Security benefits. However, there are some that do. If you live in these states, your Social Security benefits could be taxable on the state level as well as federal:
- Colorado
- Connecticut
- Kansas
- Minnesota
- Missouri
- Montana
- Nebraska
- New Mexico
- Rhode Island
- Utah
- Vermont
- West Virginia
There are a couple of things to note here. First, Missouri and Nebraska plan to stop taxing Social Security benefits in 2024 and 2025, respectively. And while a few of these states use the same general tax structure for Social Security benefits as the IRS, most have their own exemptions and income thresholds. For example, Colorado doesn't tax any Social Security income for recipients aged 65 and older.
3. If your benefits are taxed, the money goes back into the program
Finally, it's important to be aware that if your Social Security income is taxable, it is used for a very specific purpose – to help fund Social Security itself. The primary source of Social Security funding is payroll taxes that are paid by employers and their employees, but taxation of benefits on retirees with significant other retirement income is a significant source of revenue as well.
In 2022, Social Security took in $1.22 trillion in income and paid out a little over $1.24 trillion in benefits, leading to a deficit of about $22 billion for the year, which was covered by the program's reserves in its trust fund. However, if it weren't for the taxation of Social Security benefits, the shortfall would have been nearly $70 billion.
