Social Security is an essential part of nearly every American's retirement plans. Almost 9 out of 10 retirees say Social Security is a major or minor source of income in retirement, according to an annual poll from Gallup. So keeping as much of those monthly checks as you can could play a critical role in your ability to enjoy your retirement.
Taxes on Social Security can be extremely complicated, and there are some big pitfalls you could find yourself falling into if you're not careful. It's important to understand the basics of how taxes on Social Security work. Then you'll be able to understand how various retirement strategies could end up with major surprises come tax time.
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How the federal government taxes Social Security
The federal government uses a metric called "combined income" to determine what portion, if any, of your Social Security benefits are taxable at the federal level. Combined income is equal to the sum of your adjusted gross income, non-taxable interest income, and 50% of your Social Security income.
If your combined income exceeds the thresholds detailed in the table below, a portion of your Social Security benefits will become taxable.
| Taxable Portion of Benefits | Single Filers | Joint Filers |
|---|---|---|
| 0% | Less than $25,000 | Less than $32,000 |
| Up to 50% | $25,000 to $34,000 | $32,000 to $44,000 |
| Up to 85% | More than $34,000 | More than $44,000 |
Data source: Social Security Administration.
As you can see, those thresholds are relatively low. That's because they haven't been updated for inflation for at least 30 years. So keeping your combined income as low as possible is necessary to avoid taxes on Social Security.
While you can't exercise control over your Social Security income once you start collecting it, many retirees have some flexibility in their overall adjusted gross income. Much of that income will be made up of retirement account withdrawals and capital gains from investments in retirement. And those two areas can represent big pitfalls for your taxes in retirement, along with one other factor.
Pitfall No. 1: Capital gains
The U.S. tax code gives a lot of preferential treatment to long-term investors. In fact, many retirees can often sell long-term stock and bond holdings without any tax liability, thanks to a generous 0% tax bracket for capital gains.
The long and short of it is, if you keep your taxable income (including capital gains) below $47,025 for single filers or $94,050 for joint filers, you won't pay any taxes on long-term capital gains in 2024.
However, just because you won't pay taxes on those capital gains doesn't mean they don't add to your adjusted gross income. And by extension, they add to your combined income, which can make more of your Social Security income taxable. While you won't pay taxes directly on taking more capital gains than you need in retirement, you may end up paying more on your overall tax bill because of the Social Security tax.
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Pitfall No. 2: 401(k) and IRA withdrawals and conversions
Another common source of retirement income is to withdraw funds from retirement accounts like a 401(k) or IRA. The IRS taxes those withdrawals just like regular income, and they count toward your adjusted gross income.
It's possible to avoid paying taxes on retirement account withdrawals by only withdrawing up to the standard deduction. For married couples with one spouse 65 or older filing jointly, the standard deduction in 2024 is $30,750.
Even if you only withdraw up to the standard deduction, you'll push a significant portion of your Social Security income into your taxable income under the federal rules. That's because Social Security income starts becoming taxable when your combined income exceeds $32,000, per the table above.
Many retirees are considering Roth conversions in order to lock in current tax rates. The tax code is scheduled to revert to pre-2018 tax rates starting in 2026, so locking in a 10% or 12% income tax rate while they're available is appealing to many.
To lock in those rates, a retiree can simply convert funds from a traditional IRA to a Roth IRA and pay the taxes this year. However, there could be an added cost if that conversion results in more Social Security income becoming taxable.
Pitfall No. 3: Ignoring state taxes
Even if you carefully manage your finances to avoid significant taxes on the federal level, you could end up paying for it at the state level.
There are 10 states that will tax some Social Security benefits in 2024:
- Colorado
- Connecticut
- Kansas
- Minnesota
- Montana
- New Mexico
- Rhode Island
- Utah
- Vermont
- West Virginia
Each state has different tax laws when it comes to how they tax Social Security. Many have higher exemption limits than the federal tax laws. If you're not sure how your state determines what percentage, if any, of your Social Security is considered taxable income, it could pay to consult an accountant or financial planner to understand how various financial moves will impact your tax bill.
While taxes shouldn't be the determining factor in where you decide to retire, you do need to remain mindful of state taxes. Since relatively few states tax Social Security, it can often slip through the cracks in common retirement planning advice. But for those people that it affects, state taxes can play a significant role in your retirement budget.
Simply being mindful of these common tax pitfalls can help you make the most of your Social Security benefits in retirement.
