Choosing where to retire involves multiple considerations, with common factors including climate preferences and closeness to loved ones. However, one often underappreciated factor that can materially impact a retiree's finances is the taxation of Social Security benefits. While many retirees understand that their 401(k) distributions are taxable, it is less widely recognized that Social Security income may also be taxed, both at the federal and state levels.
Even though individuals contribute to the Social Security system through payroll taxes for much of their working lives, a portion of their Social Security benefits could be subject to taxation when they begin receiving them. Fortunately, the taxation of these benefits varies significantly depending on the state of residence, with many states choosing not to tax Social Security income at all.
States Without State-Level Social Security Tax
Currently, there are 42 states plus the District of Columbia that do not levy a tax on Social Security benefits. These are:
- Alabama
- Alaska
- Arizona
- Arkansas
- California
- Delaware
- Florida
- Georgia
- Hawaii
- Idaho
- Illinois
- Indiana
- Iowa
- Kansas
- Kentucky
- Louisiana
- Maine
- Maryland
- Massachusetts
- Michigan
- Mississippi
- Missouri
- Nebraska
- Nevada
- New Hampshire
- New Jersey
- New York
- North Carolina
- North Dakota
- Ohio
- Oklahoma
- Oregon
- Pennsylvania
- South Carolina
- South Dakota
- Tennessee
- Texas
- Virginia
- Washington
- West Virginia
- Wisconsin
- Wyoming
Among the most recent additions to this list are West Virginia, phasing out its tax by 2026, Kansas, Missouri, and Nebraska, which are slated to eliminate taxation on Social Security benefits by 2024, and North Dakota, which ended its tax on these benefits in 2021. States often enact such measures to attract or retain retirees, hoping to gain economic benefit from their expenditures and other tax payments within the state.
Federal Taxation Still Applies
Even if a state does not tax Social Security benefits, retirees must be mindful of the federal tax implications tied to these payments. The federal government evaluates potential taxation of Social Security benefits based on a calculation known as "combined income." This measure comprises the sum of half of the retiree's Social Security benefits, their adjusted gross income (AGI), and any nontaxable interest income they earn.
To illustrate, consider a retiree receiving $24,000 annually in Social Security benefits, with an annual adjusted gross income of $20,000 and $1,000 in nontaxable interest income. In this case, the combined income calculation proceeds as follows:
$12,000 (half of $24,000 Social Security benefits) + $20,000 (AGI) + $1,000 (nontaxable interest) = $33,000 (Combined Income)
The Internal Revenue Service then uses this combined income figure to determine whether and how much of the Social Security benefits are subject to federal income tax. The thresholds and corresponding taxation levels are as follows:
| Taxable Percentage | Filing Single | Married Filing Jointly |
|---|---|---|
| 0% | Less than $25,000 | Less than $32,000 |
| Up to 50% | $25,000 to $34,000 | $32,000 to $44,000 |
| Up to 85% | More than $34,000 | More than $44,000 |
Using the example above, if the individual files taxes as single, a portion of their Social Security benefits could be taxable since their combined income is $33,000. Up to 50% of the Social Security benefits, equating to a maximum of $12,000, may be considered taxable income and taxed accordingly at their applicable federal income tax rate.
It is important to note that the majority of retirees fall below these income thresholds and thus avoid paying federal taxes on their Social Security income altogether.
Conclusion
When planning retirement locations and finances, the tax treatment of Social Security benefits is a significant consideration. While the majority of states do not impose a state income tax on these benefits, federal taxation still governs the extent to which Social Security income is taxed, based on combined income thresholds. Retirees should carefully evaluate their expected income sources and tax obligations at both the state and federal levels to optimize their retirement income.