This Least Tax-Friendly State Could Give Social Security Recipients a Long Overdue Break

By Sean Williams Markets Fool.com

For many Americans, Social Security provides the foundational income upon which their retirement is built. A lifetime of poor savings habits has, according to the Social Security Administration, led more than 60% of currently retired workers to rely on their benefits to comprise at least half of their monthly income. Without this income, it's pretty safe to assume that many more seniors would be living below the poverty rate.

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Things aren't much different for the future generation of retirees, either. According to a 2016 report from the Insured Retirement Institute, 59% of baby boomers who weren't yet retired intimated that they would be counting on Social Security as a "major" source of income during their retirement.

Image source: Getty Images.

Social Security's funding shortfall is rapidly approaching

Unfortunately, this vital source of income for seniors is facing an imminent funding shortfall. According to the Social Security Board of Trustees report from last year, the program is expected to exhaust its more than $2.8 trillion in excess cash by the year 2034. This is as a result of baby boomers retiring and weighing down the worker-to-beneficiary ratio, as well as life expectancies steadily lengthening over the past five decades. The Trustees report has suggested that a 21% across-the-board cut in benefits may be needed to sustain payouts through 2090.

The end result is that newly retired seniors, along with pre-retirees and today's working Americans, may be forced to do with less when they retire. Thankfully, they won't have to worry about insolvency, since Social Security derives nearly all of its revenue from the payroll tax on working Americans. As long as people keep working, Social Security will continue to collect revenue that it can disburse to its more than 61 million recipients (two-thirds of whom are retired workers).

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Surprise! You'll probably pay tax on your benefits

A benefits cut, however, isn't the only concern that retirees have to face. Most of them may also be surprised to find out that they'll likely owe some federal income tax on their Social Security benefits.

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In 1983, Congress passed a smorgasbord of amendments to Social Security. It was the last time such a series of major amendments was made to the program. One of those amendments included the introduction of federal income taxation over a certain threshold of income. Individuals with more than $25,000 and joint filers with more than $32,000 in earned income could have 50% of their Social Security benefits exposed to federal ordinary income taxes.

Another tier of taxation was added in 1993. Any individual with more than $34,000 and couples with more than $44,000 in earned income could have 85% of their Social Security benefits taxed at the federal ordinary income rate.

When it was first introduced in 1983, the taxation of benefits was only expected to impact about one in 10 households. By 1993, it was fewer than one in five households. As of 2015, according to The Senior Citizens League (TSCL), it was affecting well over half of all seniors. The problem, as told by TSCL, is that lawmakers haven't adjusted the taxation thresholds for inflation in 34 years. This means that more than half of all Social Security recipients are parting with cash they may need for retirement.

States might tax you, too

As if that weren't bad enough, there are a handful of states that tax Social Security benefits as well.

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Here are the 13 states that currently tax Social Security income:

  • Colorado
  • Connecticut
  • Kansas
  • Minnesota
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • North Dakota
  • Rhode Island
  • Utah
  • Vermont
  • West Virginia

Of course, not all states that tax Social Security are inherently bad places to retire in. Both Rhode Island and Missouri have pretty high adjusted gross income exemptions for individuals and couples. On the other hand, Minnesota, North Dakota, Vermont, and West Virginia have no such exemptions, and have chosen to follow the federal taxation schedule. If you live in any of these states, you may have to fork over even more in taxes.

This least tax-friendly state may finally give Social Security recipients a break

However, one state that Kiplinger has dubbed among the least tax-friendly in the U.S. could be on the precipice of giving Social Security beneficiaries a much-deserved break.

According to the financial publication,Minnesota has an average combined state and local tax rate of 7.27% (based on the Tax Foundation's data), an income tax range of 5.35% on the low end to 9.85% on the high end, and its Social Security taxation mirrors that of the federal government. This means individuals earning more than $25,000 and couples with more than $32,000 annuallyare going to pay tax on a portion of their Social Security benefits.

Minneapolis, Minn. skyline. Image source: Pixabay.

Last week, Minnesota House Republicans introduced legislation that would cut $1.35 billion in taxes from state's budget, which is doable since it is expected to run a $1.65 billion surplus. A significant component of this $1.35 billion tax reduction ($270 million) comes in the form of Social Security tax reforms.

Though the precise figures are still being debated, MPR News has reported that Republican House tax chair Greg Davids wants to double the Social Security income thresholds for married couples from $32,000 to $64,000. No mention is made of the individual tax thresholds, but one can only assume they would double to $50,000 as well. According to Davids:

I'd just like to eliminate the tax on Social Security, but we don't have the funds to do that. So, what we're doing is we're raising the income threshold for our seniors so less of their income will be taxed and some people will not have to declare any of the income on their Social Security.

It's unclear just how much of a Social Security tax break seniors in Minnesota could be in line for, but it's pretty clear that something positive appears headed their way.

And this isn't the first instance of a Social Security-taxing state looking to change the perception that it is unfriendly to retirees. Just a month ago, various news sources reported that lawmakers in Connecticut were tinkering with the idea of doing away with the state-level taxation of Social Security benefits. Admittedly, it could be a bit tougher to eliminate state-level Social Security taxes in Connecticut given that it is expecting an estimated budget shortfall of $1.7 billion, which is a far cry from Minnesota's surplus of $1.65 billion.

Nonetheless, that's two of 13 states in a matter of a month. This could represent a new and promising trend for seniors. It's important not to count your chickens before they're hatched, but it's possible that both Minnesota and Connecticut could prove considerably friendlier to senior citizens in the months and years to come.

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