Throughout their working lives, most Americans contribute payroll taxes that fund the Social Security system, which later provides retirement benefits. However, upon reaching retirement age and beginning to collect these benefits, recipients should be aware that Social Security income is considered taxable in the eyes of both state and federal governments, though with variations depending on the jurisdiction.
At the state level, the landscape has shifted over time, with the majority of states eliminating taxes on Social Security benefits. Nonetheless, eight states have maintained taxation policies that subject these benefits to state income taxes. The states that currently tax Social Security benefits include Colorado, Connecticut, Minnesota, Montana, New Mexico, Rhode Island, Utah, and Vermont.
The specific mechanisms and protections vary among these states. For instance, Utah offers a nonrefundable tax credit against Social Security taxes, which can alleviate or fully offset the state tax burden on these benefits depending on the retiree's circumstance. Other states, like Connecticut and New Mexico, offer exemptions or reduced tax liabilities for retirees with lower incomes, making the taxation less burdensome for those with limited retirement funds.
It is important to note that while Social Security benefits are free from local taxation, they remain subject to potential state and federal taxation. This dual-level tax structure means retirees should consider both when planning their retirement finances.
Federal taxation of Social Security benefits depends on the beneficiary's "combined income." This combined income is calculated by adding half of the annual Social Security benefits, the individual's adjusted gross income (AGI), and any tax-exempt interest received, such as income from certain municipal bonds. The resulting figure determines the extent to which Social Security benefits will be federally taxed.
For individual filers, if the combined income is less than $25,000 annually, Social Security benefits remain untaxed by the federal government. If the combined income is between $25,000 and $34,000, up to 50% of the benefits may be taxable. When the combined income exceeds $34,000, up to 85% of benefits can be subject to taxation.
In the case of married couples filing jointly, the thresholds are higher. Combined incomes below $32,000 are exempt from federal taxation on Social Security benefits. Between $32,000 and $44,000, up to 50% of benefits may be taxed federally, and amounts above $44,000 can incur taxes on up to 85% of the received benefits.
To illustrate, consider a married couple with an annual Social Security benefit income of $24,000, an AGI amounting to $20,000, and $500 in tax-exempt interest. Their combined income calculation would be $12,000 (half of Social Security) plus $20,000 (AGI) plus $500 (tax-exempt interest), totaling $32,500. This figure places them within the range where up to 50% of their Social Security benefits can be included in taxable income for federal tax purposes.
It is critical to understand that the stated percentages pertain to the portion of Social Security benefits that may be included in taxable income rather than a direct tax on that percentage of the benefits themselves. The actual tax liability depends on the total income, available deductions, and the taxpayer's marginal federal income tax rate.
In summary, retirees must navigate a nuanced tax environment regarding Social Security benefits. While state taxation has been largely reduced or eliminated across the country, the eight states that still impose such taxes do so with varying degrees of retiree assistance and credits. Additionally, federal tax obligations are triggered by combined income thresholds, influencing how much of the Social Security income becomes taxable. This complex framework requires careful attention by retirees to manage their taxable income and plan effectively for retirement.