To get Social Security retirement benefits, you have to work for at least 10 years, and therefore many retirees see their Social Security checks as something they've earned. Yet that doesn't stop Uncle Sam from taking its cut of your benefits in the form of income taxes. Not everyone on Social Security has to pay tax, but those who do can end up having to include as much as 85% of their benefits as taxable income on their tax returns. Below, we'll look more closely at how taxation of Social Security works and just how much the typical American ends up having to include on their tax returns.
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Why would you have to pay tax on Social Security?
In 1984, the federal government ran into its first Social Security funding crisis. As part of the solution, lawmakers enacted rules that made benefits taxable in some cases. Specifically, if you earn more than a certain amount of income from other sources while also collecting Social Security, then you'll have to add a certain amount of your benefit payments to your taxable income on your return.
The calculation for determining the portion of your Social Security benefits subject to tax is a bit complicated. The first step is to add up all of your wages, investment income, taxable pensions, and alternative sources of income other than Social Security. Then, add one-half of your total Social Security benefits for the year to that total.
As the chart above shows, if the result is greater than the first column of numbers, then you could end up paying tax on as much as 50% of your Social Security benefits. If it's greater than the numbers in the last column, then that taxable percentage could jump to as much as 85%. The actual amount depends on exactly how much you receive in benefits as well as the extent to which your income goes above those threshold amounts.
Why a rising number of Social Security recipients will get taxed on their benefits
The number of people paying tax on Social Security benefits has gone up steadily over the years. In 2014, the most recent year for which IRS data are available, about 27.4 million taxpayers included Social Security benefits on their tax returns. Of those, almost 70% -- more than 19 million -- indicated that some of their benefits were taxable.
The interesting thing about those figures is that they're far larger than lawmakers ever anticipated at the time the law was passed. Early in the provision's history in the 1980s, the threshold numbers above were set in a way that made only a small number of high-income taxpayers have to pay tax on Social Security. Over time, though, inflation has pulled more retirees into the taxable status, because the law has no provisions to let the threshold numbers rise along with the Consumer Price Index or other inflation measures.
What's even more surprising is just how much Social Security money gets taxed. Taxpayers listed a total of $575 billion in total benefits on their returns, and they calculated that they'd have to pay tax on more than $261 billion of that amount, or 45% of their total benefits. That adds up to almost $13,750 on average for those who indicated any taxable benefits, or more than $9,500 on average even when you include those who indicated a zero taxable amount.
Can you cut your tax bill on Social Security?
Avoiding this tax takes some careful planning. What trips up many people in retirement is that taxable IRA and 401(k) distributions adjust your total income higher, making more of your Social Security taxable as well. By contrast, if you have a Roth IRA or Roth 401(k), you can tap those accounts without adding to your income for these purposes, sheltering more of your Social Security income from tax.
Waiting to take benefits until later in your retirement can also help you avoid the tax. Many people claim early Social Security benefits even while they still have jobs, but the odds are much larger in that situation that your work income will push you over the thresholds. The same is true for married couples in which one spouse has retired but the other is still working. If you wait until that income goes away before taking benefits, your monthly payments will be larger and they might be less likely to be subject to tax.
Lastly, timing your income can sometimes reduce your long-term tax bill. For instance, many retirees wait as long as possible before starting to withdraw money from IRAs and 401(k)s. But at age 70 1/2, most people have to start taking withdrawals from traditional retirement accounts. If you have some room under the Social Security tax threshold, then taking withdrawals earlier than necessary could actually save you tax in the long run.
No one likes to pay tax, and many see taxes on Social Security benefits as being unfair. However, if you know the rules, you can find ways to save as much as you can on your taxes in retirement.
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