Think Social Security Benefits Are Tax-Free? Think Again.

When you’re planning how much income Social Security will provide, it’s important you understand how much of your benefits you’ll get to keep.

Unfortunately, many Americans make a big mistake in this regard because they assume their benefits won’t be taxed due to the fact these are earned benefits received through the Social Security taxes on their wages throughout their careers.

Sadly, this mistake could be very costly. Here’s why.  

1040 form with pen and calculator sitting on it.

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Around 50% of retirees lose some of their benefits to taxes

The reality is, only about half of all retirees get to keep all of their Social Security money. And even fewer will pocket the full amount of their benefits in the future. That’s because, as research from the Senior Citizens League shows, around 50% of beneficiaries are currently subject to federal tax on their benefits. And the number of people who are going to have to pay this tax is only growing.

Taxes kick in on Social Security once your provisional income reaches a certain threshold. And more people are soon going to have income above that threshold. That’s because Social Security benefits increase over time, not just because of cost of living adjustments (COLAs) but also because wages rise year over year for most people. Your Social Security benefit is based on your average earnings over your career. With average wages going up, benefits rise. And with incomes going up, usually this means you’ll also have more money from a pension (if you receive one) and more money in your 401(k) to provide retirement income. 

Unfortunately, although your combined annual income as a retiree may be rising, your buying power isn’t necessarily going up. Because of inflation, $10 in 10 years won’t buy you the same amount of goods as it does today. You’ll need more money to maintain the same standard of living. So, if you’re retiring in the future, you’ll probably have a higher income than today’s retirees because of wage growth, but your buying power may be around the same or less.  

The big problem with that is, the threshold at which you’re subject to tax on your benefits won’t change. That means the Social Security benefits tax will apply to a growing number of low- and middle-income Americans rather than just the wealthiest retirees who used to be the only ones faced with an IRS bill.

Just how low are the thresholds for Social Security tax?

Under the Social Security rules, benefits are not taxed at all until your provisional income reaches $25,000 for single filers and $32,000 for married joint filers. With income above this level, you’re taxed on up to 50% of your Social Security. And if your income exceeds $34,000 for single filers or $44,000 for married joint filers, you’ll be taxed on up to 85% of your benefits.

But provisional income isn’t all your income. It’s all your taxable income, plus half your Social Security benefits plus some nontaxable income. That means if you make the average Social Security benefit of $1,543 per month in 2021, only $9,258 of your annual benefit would count toward your provisional income, and you could earn $15,472 in other countable income before owing taxes as a single filer. 

But around half of all retirees are already above this threshold, and more will be every year as Americans retire with larger incomes due to wage growth. And while it’s possible that these thresholds could change, it’s unlikely since Social Security is already facing financial trouble and taxes on benefits serve as an important source of the program’s income.  

As you plan for retirement, you need to determine if you’ll be subject to these taxes, as well as whether you’ll be taxed on benefits in your state as well. If you’ll owe the IRS or your state government, you need to budget accordingly and make sure you can live on what’s left of your Social Security checks along with your savings.

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