Despite a popular misconception, Social Security benefits are sometimes subject to taxation, but not to the same extent as traditional IRA distributions.
The youngest baby boomers are approaching the age of eligibility for Social Security, while the oldest have been receiving benefits for several years. For most, those monthly payouts will be an increasingly important source of financial well-being, but two recent surveys highlight potentially costly knowledge gaps about the taxation of Social Security benefits.
More than half of adults surveyed by the Nationwide Retirement Institute incorrectly agreed with this statement: “Social Security benefits are tax free.” Similarly, more than half of adults nearing retirement age surveyed by MassMutual incorrectly agreed with this statement: “Social Security retirement benefits are subject to income tax just like withdrawals from a traditional IRA account.”
Here’s what baby boomers need to know about taxes on Social Security benefits.
Retirees might owe federal income tax on benefits
Social Security benefits and traditional IRA withdrawals can both be subject to federal income tax, but not to the same extent. Every dollar from a traditional IRA is counted as taxable income. But Social Security gets taxed only when taxpayers exceed certain thresholds for combined income, which are determined by adjusted gross income plus nontaxable interest plus one-half of Social Security benefits. Moreover, only a portion of Social Security benefits are subject to federal taxation even above those thresholds.
The chart below details the taxable portion of benefits at different combined income thresholds for single individuals and married couples filing jointly. The precise calculation of how much of a person’s benefits gets taxed is complicated, and many people end up including less than the 50% or 85% amounts noted below in their taxable income.
| TAXABLE PORTION OF BENEFITS | SINGLE FILERS | JOINT FILERS |
|---|---|---|
| 0% | Under $25,000 | Under $32,000 |
| Up to 50% | $25,000 to $34,000 | $32,000 to $44,000 |
| Up to 85% | Above $34,000 | Above $44,000 |
DATA SOURCE: SOCIAL SECURITY ADMINISTRATION..
The combined income thresholds shown above were intended to target high earners. Indeed, only 10% of Social Security recipients owed tax on benefits when the first thresholds took effect in 1984. But Congress has never adjusted those thresholds for inflation, so the tax burden now falls on a much broader portion of the population.
More than half of recipients now owe tax on benefits because annual cost-of-living adjustments have pushed payouts higher over time. In other words, the federal government is effectively taxing Social Security more aggressively with each passing year. That means retirees who don’t currently pay tax on benefits could find themselves above the thresholds in the future.
This calculator from the Internal Revenue Service (IRS) can help beneficiaries determine what portion (if any) of their Social Security income is taxable. Those who owe tax on benefits have two options: They can make quarterly estimated payments to the IRS or request that the Social Security Administration withhold a portion of benefits by completing a Form W-4V.
Retirees might also owe state income tax on benefits
Traditional IRA withdrawals are generally subject to state income tax, but with certain exceptions. Specifically, nine states do not tax income at all and another three states do not tax 401(k) plans, IRAs, or Social Security benefits. That means 12 states do not tax retirement income of any kind — and Iowa will join that list in 2023, bringing the total to 13 states. But traditional IRA distributions are counted as taxable income in the remaining states.
Social Security works a little differently. Most states do not tax benefits at all, and in the 12 states that do tax Social Security, the extent to which benefits are taxed is typically limited by state-specific deductions and exemptions. Also noteworthy, Missouri and Nebraska plan to stop taxing Social Security benefits in 2024 and 2025, respectively.
Retirees with incomes over thresholds should plan to keep paying federal income tax on Social Security benefits
Unfortunately, the federal government has no plans to stop taxing Social Security benefits, so recipients are unlikely to see such a change on that front anytime soon, simply because the program is already expected to run a $22.4 trillion deficit through 2097.
Social Security is primarily financed by a dedicated payroll tax, but its trust fund interest and taxes on benefits are also important sources of funding. Cash inflows across all three revenue streams totaled $1.22 trillion last year, as detailed below:
- Payroll taxes: 90.6%
- Interest: 5.4%
- Taxation of benefits: 4%
The taxation of benefits is the smallest of the three revenue streams, but it is by no means unimportant. The financing problem mentioned above threatens to deplete the Social Security trust fund by 2034, and it can only be resolved by increasing revenue, cutting benefits, or some combination of the two.
Eliminating one of the three revenue streams would be a step backwards, which means lawmakers are unlikely to pursue such changes until the more pressing problem is resolved.
