Image source: SSA Office of the Inspector General.
Many Americans don't realize that the Social Security benefits they receive in retirement can be subject to income tax. But millions of Americans will find out in the years to come, because the percentage of Social Security benefits that they'll end up returning to Uncle Sam in the form of income taxes will rise dramatically, according to a study from the Social Security Administration.
How much will income taxes on Social Security rise?
In the past, most of those who paid income taxes on their Social Security benefits are among the top half of income earners. The quarter of the American population that had the highest income paid about 14% of their benefits to the government in 2010 in the form of income taxes. That compared to just 5% for those in the second-highest 25% of the population, and the bottom half of the income distribution paid 0.5% or less of their benefits in income tax.
But the SSA sees that percentage rising dramatically, and most of the additional burden will be on the middle class. By 2025, the percentage of benefits that upper-middle class Americans pay in taxes on their benefits will have doubled to almost 10%, and families in the second-lowest 25% of the income distribution will have seen their tax liability rise sixfold to 3%.
Data source: Patrick J. Purcell, Income Taxes on Social Security Benefits, Social Security Administration.
As you can see above, that trend will continue into the future. As time passes, the tax rate on upper-income Americans flattens out, but taxes on lower-income Americans continue to rise. Although progressivity ensures that the rates don't converge, lower-income families have much less flexibility to give up even a small portion of their financial resources in taxes.
Why will income taxes on Social Security rise?
The main reason why people will pay more of their Social Security benefits in income taxes has to do with the formula the IRS uses. In order to figure out how much of your benefits you have to include in taxable income, you have to total up all of your taxable income, and then add in half of your Social Security benefits. If that figure is more than $25,000 for single filers or $32,000 for joint filers, then up to half of your benefits can get taxed. If it's above $34,000 for singles or $44,000 for joint filers, the maximum percentage of your benefits included in taxable income rises to 85%.
Most IRS formulas are indexed for inflation, but the one that calculates Social Security taxation isn't. Therefore, as inflation pulls wages up, more people will pass the dollar thresholds listed above. Unless lawmakers add an inflation index provision, a law that initially affected only high-income taxpayers will slowly but surely affect all Americans.
How you can protect your benefits
If you want to pay less in taxes on your Social Security benefits, you need to take action now. By taking steps to reduce taxable income in retirement, you can protect more of your benefits from tax.
One method of doing so is to use Roth IRAs and Roth 401(k) accounts to a greater extent. Unlike with traditional retirement accounts, you don't have to pay income tax when you withdraw money from these Roth retirement accounts. In addition, the SSA doesn't make you include withdrawn funds from a Roth in the calculation for taxing Social Security benefits.
Other than that, a lot has to do with timing income. Selling stocks at a gain or taking big retirement distributions can boost your income and make more of your Social Security taxable. Using tax-loss harvesting and other methods to reduce your taxable income can also leave more of your Social Security benefits intact.
Overall, the typical American will pay more income taxes on Social Security, but you don't have to be typical. By planning now, you can prepare and save on taxes years or even decades down the road.
