Most Americans spend their careers paying into the Social Security system through payroll taxes; it's primarily funded that way. Unfortunately, when you begin receiving benefits in retirement, they're treated like other forms of income and may be subject to taxes.
On the bright side, most states have eliminated their Social Security tax. On the not-so-bright side, eight states still tax Social Security benefits. Read on to see which side your state falls on.
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What states still tax Social Security?
The eight states that do tax Social Security benefits are:
- Colorado
- Connecticut
- Minnesota
- Montana
- New Mexico
- Rhode Island
- Utah
- Vermont
The specific rules vary by state, with some being more retiree-friendly than others. For example, Utah offers a nonrefundable tax credit that can offset all or part of the tax, while others, like Connecticut and New Mexico, exempt the tax for lower-income retirees.
You can't forget about federal taxes
Most Americans have their income taxed at the state and federal levels, and in some cases, the local levels. Luckily, your Social Security benefit is free from local taxes and potentially free from state taxes, but unfortunately, you may still pay federal taxes on it.
How much you pay in federal taxes depends on your "combined income." This is the combination of half of your annual Social Security benefit, your adjusted gross income (AGI), and any nontaxable interest you may receive (such as certain bonds).
If you're single and your combined income is under $25,000, you're free from federal taxes. If it's between $25,000 and $34,000, up to 50% could be taxed. If it's more than $34,000, up to 85% could be taxed.
If you're married and filing jointly and your combined income is under $32,000, you're free from federal taxes. If it's between $32,000 and $44,000, up to 50% could be taxed. If it's more than $44,000, up to 85% could be taxed.
Seeing federal taxes in action
Let's assume you receive $24,000 annually in Social Security, have an AGI of $20,000, and receive $500 in tax-exempt interest. In this situation, your combined income would be $32,500 ($12,000 + $20,000 + $500). If you're married and filing jointly, this means up to 50% of your income could be subject to federal taxes.
What this doesn't mean, however, is that your benefits will be taxed 50%. Instead, up to 50% of your benefits ($12,000 in this case) would be added to your other forms of income and then taxed at your normal federal income tax rate.
