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Minnesota is one of 13 states that imposes state taxes on Social Security benefits. Source: Minnesota Revenue.

This article was updated on Feb. 29, 2016.

More than 60 million Americans receive Social Security benefits, with retired workers and their families making up the lion's share of all recipients. With the average Social Security payout among retired workers being just under $1,350 per month, retirees have to squeeze as much as they can from every dollar they get. Yet while the vast majority of states in the U.S. let retirees keep every penny of Social Security they earn, 13 states impose at least some state-level income taxes on benefits. If you live in one of them, it could make your retirement finances more difficult.

A taxing situation for retirees
The 13 states that impose some form of state income tax on Social Security recipients fall into three general categories. One group mirrors the federal tax rules covering Social Security taxation. Under those rules, you take half of your Social Security benefits and add it to the remainder of your income. If that amount is between $25,000 and $34,000 for single filers or between $32,000 and $44,000 for joint filers, then up to 50% of your benefits can get added to your taxable income. Above those higher thresholds, the maximum amount subject to tax rises to 85% of your benefits.

Ss State Tax Group
Images courtesy U.S. Mint.

The states that fall into this first category are Minnesota, Nebraska, North Dakota, Rhode Island, Vermont, and West Virginia.

Meanwhile, a second group of states imposes tailored rules on how much Social Security income their residents have to include on their state tax returns. The specific rules vary from state to state:

  • Colorado offers a retirement income exclusion that can allow recipients to earn up to $20,000 in Social Security and other retirement income free of state tax if they're under age 65. Residents aged 65 and older can exclude up to $24,000 in retirement income.
  • In Connecticut, single filers earning less than $50,000 and joint filers with income less than $60,000 can deduct all their Social Security income for state income tax purposes. Those who exceed those amounts can deduct 75% of their Social Security income on their state tax returns.
  • Kansas residents who earn less than $75,000 have all their Social Security income exempt from state tax.
  • Missouri makes Social Security income exempt from state tax for single filers earning less than $85,000 or joint filers with income less than $100,000.
  • In Montana, Social Security is generally taxable in a similar way to how the federal government taxes it, but slightly different income thresholds apply to determine the taxable amount.
  • New Mexico allows everyone aged 65 or older to exempt up to $8,000 of income. That can include Social Security benefits or other types of income, but any additional amount is subject to tax.
  • Utah offers a retirement tax credit of up to $450 per person to those 65 or older, which retirees can use to offset taxes on any taxable Social Security benefits. In addition, those under 65 can get a 6% tax credit against tax paid on taxable Social Security benefits and other eligible retirement income.

Ss State Tax Group
Images courtesy U.S. Mint.

As you can imagine, no one wants to pay any more tax than they have to on their Social Security benefits. In fact, many recipients are surprised when they discover that they might have to pay any tax on Social Security either at the federal or state level, as they figure that they paid taxes into the system already and therefore shouldn't have to pay any tax when they draw benefits out.

Yet while American taxpayers don't have much choice but to pay federal taxes on their benefits, any taxes at the state level are a different matter. As times get tougher, those nearing retirement have had to pay more attention to what their expenses will be after they retire, and taxes can play a vital role in determining whether it makes sense to move at the end of your career. Moreover, states have a strong incentive to hang on to high-income individuals who are most likely to pay state-level taxes under these rules, and the potential for high-net-worth individuals to flee to lower-tax jurisdictions has huge implications for states' long-term revenue projections and continued ability to provide key services for residents.

States are getting the message

Retired People Ian Mackenzie Flickr

Source: Ian MacKenzie via Flickr.

Fortunately, states have started to realize that taxing Social Security can incentivize in-state retirees to leave and also hinder efforts to attract retirees from other states. As a result, some states have made moves toward exempting Social Security income from state taxation. Iowa, for instance, recently came off the list, as the Midwestern state gradually phased out its taxes on Social Security income over a seven-year period that ended in 2014. Minnesota has been considering legislation to do the same thing, in the hopes that fewer residents will leave the state after retiring.

At the same time, though, it's important to look at Social Security taxation in the proper context. For many Social Security recipients who have relatively low incomes, state taxes never come into play. You also have to consider other factors when choosing a state to live in during retirement, including not only property and sales taxes, but also the costs of housing, food, and other necessities.

Regardless, state taxes on Social Security income just make a state look bad. As different states compete for the tax revenue from serving retirees, you can expect more of these 13 states to reconsider their past stances and consider exempting Social Security from taxation in the future.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.