There are millions of retirees who rely on Social Security as their primary source of income and many are surprised that even though some states may not tax Social Security benefits, the federal government still does. To some, it may be confusing because you may not pay state taxes, but when you file your federal income tax return, you find that you may owe money.
Federal Rules Apply No Matter Where You Live
It’s important to remember that state taxes and federal taxes are separate. There are some states such as Nevada, Florida, Texas and Tennessee that do not tax Social Security at all. However, there are other states that have partial exemptions and specific rules.
Even if you live in a state that promises “no tax on Social Security,” you are still required to follow federal tax rules. Depending solely on your income level, the federal government determines whether a part of your Social Security payments is subject to tax using its own calculation.
How the IRS Determines Whether Your Benefits Are Taxable
The IRS uses something called “combined income” to decide if your benefits are taxable. Combined income includes:
- Your adjusted gross income (AGI)
- Any non-taxable interest you receive
- Plus, half of your annual Social Security benefits
This number is then compared to federal income limits to determine whether you owe taxes.
The Federal Income Limits: Who Pays Taxes and Who Doesn’t
The IRS has different thresholds:
If You File as a single individual:
- If your income is less than $25,000 combined, you do not owe federal tax.
- If your income is between $25,000 and $34,000 then up to 50% of your Social Security may be taxable.
- If your income is more than $34,000 then up to 85% of your benefits may be taxed.
If You File Jointly (Married Filing Jointly)
- Should your combined income be less than $32,000, there is no federal tax on Social Security.
- If your income is between $32,000 and $44,000, then up to 50% of your benefits may be subject to tax
- If your income is more than $44,000, you can expect up to 85% of your benefits to be taxed (most likely).
If You’re Married but File Separately
Unfortunately, in most cases regardless of your income, up to 85% of your benefits may be taxed. In essence, filing separately doesn’t really save you money.
Why So Many Retirees End Up Paying Federal Taxes
The aforementioned income restrictions, some of which date back to the 1980s, have not been updated for inflation since they were established, which is one of the main reasons why so many individuals owe federal taxes on Social Security.
This means simply means that even though the costs have increased, but the limits have not.
Why State Taxes Don’t Change Your Federal Tax Bill
There are many states that make the choice not to tax Social Security because they want retirees to manage and keep up with the cost of living. This is quite common in states which have dominating senior residents.
However, it’s important to note that the IRS does not follow state rules. Even if states don’t tax your Social Security benefits, the federal government has different rules and may tax your benefits.
Ways Retirees Can Reduce or Manage Their Tax Bill
Unfortunately, you cannot avoid federal rules, however you can reduce your taxable income in legal ways:
- Where possible, delay claiming Social Security benefits and withdraw any other savings you have, first.
- To prevent going over a threshold, spread out withdrawals.
- Seek assistance from a financial advisor to help you plan your income and make it worthwhile for you.
The Bottom Line
It’s important for beneficiaries to understand that even though your state does not tax Social Security, federal taxes may still be applicable.
With that being said, beneficiaries are urged to plan ahead and budget accordingly. Making wise and proactive decisions now will safeguard your benefits in the future. If need be, consult with a financial advisor to assist you.