At tax time, you may need to count in Social Security benefits

Social Security is an important part of many Americans’ retirement income, especially as people are living longer. But with the full retirement age raised to 67 from 65 and the cost-of-living continuing to increase, every last penny counts. 

Most people associate Social Security with retired Americans. The elderly are especially dependent on the program, with almost nine out of 10 Americans aged 65 and older collecting benefits to make ends meet. 

But Social Security offers help to more than just older people. One in five Americans, or about 67 million people, receive the monthly benefits, including the dependents of beneficiaries, people with disabilities and survivors of deceased workers.

“Most people are going to rely on Social Security to some extent,” said Eric Bronnenkant, CPA/CFP and Head of Tax at investment advisor company Betterment. 

It may seem surprising that if you receive Social Security benefits, you still pay taxes on them. That said, not everyone does, and even if you must, the amount of taxes paid depends on your retirement income. 

It can get confusing, so here’s what you need to know.

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Why do some of us pay taxes on Social Security benefits? 

The program’s uncertain future has made headlines for years.. 

“The trajectory that we’re on right now … the Social Security system is designed to run out of money somewhere in the 2030 area,.” Bronnenkant said.

In the 1970s, it became clear Social Security was in financial peril and would need reform so it wouldn't run out of money. In 1983, President Ronald Reagan signed a new law that included taxing the benefits themselves. The idea was that higher-income American seniors could help add revenue back into the program and avoid the cutting of payouts.  

However, the federal income threshold that determines if you’ll pay taxes on your benefits and how much you’ll pay has never been adjusted. Over time, this has led to more beneficiaries having to pay.  

Who has to pay taxes on Social Security benefits and how much?

About 46% of Social Security beneficiaries pay taxes on their benefits, according to the Social Security Administration, because they “have other substantial income in addition.” Depending on what’s deemed your provisional income - which includes your gross income not counting Social Security and tax-free interest on certain financial holdings - as much as 85% of your Social Security benefits can be taxed.

For the most part, there are two groups of people who have to pay taxes on their Social Security benefits:

• If you file your federal tax return as an “individual” and your “combined income” is between $25,000 and $34,000, you may be required to pay taxes on up to half of your benefits. If your income is more than $34,000, you’ll have to pay taxes on up to 85% of your benefits. 
• If you file a joint return, and you and your spouse have a “combined income” between $32,000 and $44,000, you may be required to pay taxes on up to half of your benefits. If you make more than $44,000, that percentage goes up to 85%. 
• You’ll also probably pay taxes if you’re married but file a separate return. 

Who doesn’t have to pay taxes on their Social Security benefits?

If you’re single and make less than $25,000, excluding your benefits, then your benefits will not be taxed. You also won’t pay taxes on your benefits if you’re filing jointly and make less than $32,000 with combined income, not counting your benefits.

What’s the issue with the Social Security tax thresholds? 

Those income thresholds haven’t changed since they were introduced in the ‘80s – and have never been adjusted for inflation resulting in what some people call a stealth tax, Bronnenkant said. 

Social Security raise: 2023 COLA increase

The problem? Each year, more seniors end up crossing into the minimum thresholds and are required to pay taxes on their benefits. From 1999 to 2017, the percentage of all tax returns with taxable Social Security benefits nearly doubled, from 7.4% to 13.7%. By 2046, it’s estimated to reach over 50% according to the Congressional Budget Office. 

“The people who are the most negatively impacted are those whose wages have only been increasing because of inflation,” Bronnenkant said. “Low-income people were below $25,000 where it was tax free, and inflation has brought them right above $25,000.”

With Congress divided, changing tax laws will likely be difficult. “I don’t know where tax laws are going to be, tax funding is going to be,’’ Bronnenkant said. “It’s definitely difficult to make decisions.”   

President Joe Biden said he supports “protecting and strengthening” Social Security, but no plan was offered in his budget announced in March.

Does the state you live in affect your taxes? 

Yes, states have different laws around taxation of your benefits so make sure to check before you file your taxes. 

States that do tax Social Security benefits include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah and Vermont. These laws may use different income and age thresholds, or have a broad retirement income exemption. 

For example, in 2021, Colorado passed a law that people under the age of 65 are still eligible to pay taxes on but those who are older can deduct their benefits from their income. 

What can I do to pay less taxes on my Social Security benefits?

• “Consider delaying (Social Security) benefits until age 70 to increase benefits and draw down on Traditional IRA/401k to fund retirement before 70,” Bronnenkant said.
• Use a health savings account or HSA for qualified medical expenses and for retirement in a strategy known as “shoeboxing receipts,” which allows taxpayers to pay for their medical expenses from checking account funds, he said.. Once retired, HSA assets can be withdrawn tax-free.
• “There are some tax optimizers who have really leveraged their HSA and Roth accounts to generate retirement income. If their sole source of income in retirement is tax free Roth distributions, tax free HSA distributions, and SS benefits, an individual’s retirement could be 100% income tax free,” Bronnenkant said.