Wow! This State May Stop Taxing Social Security Benefits

By Sean Williams Markets Fool.com

Social Security is, for millions of seniors, a crucial source of monthly income. According to estimates from the Center on Budget and Policy Priorities, the mere presence of Social Security income has reduced the estimated rate of senior poverty from 40.5% to 8.8%. Data from the Social Security Administration also shows that 61% of seniors count on their benefits to make up at least half of their monthly income.

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Yet, this important program is in deep trouble. The 2016 Social Security Board of Trustees report estimates that the program could burn through its excess cash by the year 2034. Running out of spare cash doesn't mean Social Security is going bankrupt, but it does mean that benefit cuts would be needed to ensure that everyone, including future generations of retirees, keeps getting paid. The Trustees are forecasting a cut of up to 21% if Congress enacts no new laws by 2034.

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This is a terrifying thought for the aforementioned 61% of retired workers counting on Social Security to be their monthly breadwinner. But it's also far from the only surprise seniors could face once retired.

Surprise! You might owe tax on your Social Security benefits

Whether you realize it or not, your Social Security benefits may be taxable by the federal government. Worse yet, data from The Senior Citizens League (TSCL) suggests more often than not that you'll wind up owing at least some federal tax on your benefits.

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In 1983, Congress signed into law a massive overhaul of Social Security. Among the number of amendments was a new law allowing the federal government to collect tax on half of a retired workers' Social Security benefits if he or she earned more than $25,000 as an individual or $32,000 as a joint filer in a given year. A decade later, the rules were amended again to include a new benefit taxation tier. Individuals earning above $34,000 and joint filers above $44,000 could have 85% of their Social Security benefits exposed to federal income tax.

When Congress passed these amendments in 1983 and 1993, approximately 10% to 20% of households were being impacted by the taxation of Social Security benefits. Today, TSCL estimates this figure to be in excess of 50% because the tax thresholds have never been adjusted for inflation. In 2015, the federal taxation of benefits accounted for 3.4% of the $920.2 billion collected by the program.

And that's not all.

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Your state may tax your benefits, too

In addition to potentially owing ordinary federal income tax on your Social Security benefits, 13 states also tax your Social Security benefits. Four of these states -- Minnesota, North Dakota, Vermont, and West Virginia -- have no income exemptions whatsoever, meaning they follow the federal guidelines discussed above.

The other nine states -- Colorado, Connecticut, Kansas, Missouri, Montana, Nebraska, New Mexico, Rhode Island, and Utah -- do have varied levels of income exemptions. Some of the adjusted gross income (AGI) exemptions in these states are particularly high, meaning most seniors get away without owning any additional tax. Good examples would be Missouri, which has exemptions of $85,000 in AGI for individuals and $100,000 in AGI for couples, and Rhode Island, which has similar AGI exemptions of $80,000 and $100,000 for individuals and couples, respectively.

There's obviously a possible downside to retiring in these states because it could mean being hit with a double whammy of taxation from the federal government and the state on your much-needed Social Security income. Retiring in any of the other 37 states could mean you getting to keep extra income during your golden years.

This state may put the kibosh on Social Security taxation

However, one state and its lawmakers seem pretty intent on disassociating from the aforementioned taxing states.

As multiple news sources in the state reported last week, Connecticut is considering completely ditching its state tax on Social Security. It's estimated that removing the tax would save seniors $45 million annually, which is a drop in the bucket for the state's $20 billion annual budget.

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Republican lawmakers in Connecticut have previously supported repealing the taxation of benefits on Social Security, which is consistent with Republican Party views. Most Republican Social Security proposals on Capitol Hill suggest either ditching the taxation of benefits entirely or at least adjusting the thresholds for inflation (which hasn't been done in 34 years).

What's intriguing about this go-around is that Democrats within the state are leading the charge. With both parties seemingly of the same mind on this issue, the only detail left to be hashed out is whether Social Security taxation will disappear as soon as this year or if it'll be phased in over multiple years to come. Connecticut is facing an estimated budget shortfall of $1.7 billion according to the Hartford Courant, meaning cutting taxes even more could be a tough pill for legislators to swallow, even if it's for a topic they agree on.

Connecticut currently exempts the taxation of Social Security benefits on individual AGI under $50,000 and $60,000 for couples. Earn over this threshold and the amount seniors can exempt from state tax drops to 75%. The removal of this tax would presumably make Connecticut a more desirable place for retirees to live.

Could Connecticut start a trend that the other 12 Social Security-taxing states follow? That remains to be seen -- but it's certainly an intriguing start.

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