The Average American Pays Tax on 42% of Social Security Benefits. How Do You Compare?

By Dan

Source: Social Security Administration.

Millions of Americans rely on Social Security for income during retirement or in times of disability. Yet many Social Security recipients are shocked to discover that some of their benefits can be subject to income taxation. In fact, taxpayers include a surprisingly large percentage of their Social Security benefits as taxable income, essentially having the IRS eat into the limited financial resources they have during their golden years. Let's take a closer look at when Social Security benefits are taxable and how many Americans end up having to pay those taxes.

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When is Social Security taxable?Social Security benefits become taxable when your income rises above a certain level. In determining your income for Social Security tax purposes, you take half your Social Security benefits and add in other sources of income, including not only taxable items like wages and dividends but also any tax-exempt interest income you have.

Part of the worksheet needed to calculate whether your benefits are taxable. Source: IRS.

If you're single and your calculated income is more than $25,000, then as much as 50% of your benefits can get taxed. The corresponding limit for joint filers is $32,000. Moreover, an even higher "bracket" applies to singles earning more than $34,000 or joint filers with income above $44,000, with as much as 85% of benefits being subject to tax.

Income Thresholds for Taxes on Social Security Benefits

Source: IRS.

Those income limits might sound high enough that they wouldn't affect many retirees. Actually, though, a huge number of Social Security recipients pay taxes on at least a portion of their Social Security benefits, according to the most recent IRS data available from 2012. That year, 26.5 million taxpayers claimed to have received Social Security benefits, and 17.8 million -- or roughly two-thirds -- of those returns indicated that at least part of those benefits were taxable. On a dollar basis, out of a total amount of $526.5 billion in Social Security benefits, $223.6 billion, or 42%, were subject to tax. That adds up to almost $12,600 for every return that had taxable benefits, or about $8,400 even when you include those who didn't have any of their benefits taxed.

What can you do to make less of your Social Security taxable?Because the Social Security tax rules look at their specific definition of income, there are only a few things you can do to protect more of your Social Security from taxation. One common factor for married couples is that if one spouse takes Social Security while the other is still working, then their joint return will often have total income that climbs above the upper 85% threshold. If the retired spouse can delay taking Social Security until the other spouse retires, then by the time both receive benefits, their income picture will look different enough so that in many cases, less of their Social Security will go to the IRS in taxes.

Source: SSA Office of the Inspector General.

Another strategy involves prudent use of different types of retirement accounts. Specifically, although withdrawals from traditional IRAs and 401(k) plans are included in income and therefore count toward the Social Security taxation thresholds, distributions from tax-free Roth IRAs and 401(k)s do not. So if you have access both to a Roth and to a regular retirement account, doing the appropriate planning in deciding how much to take from each could make less of your Social Security taxable.

Still, the big problem facing future retirees is that it will get increasingly difficult to avoid going over those income thresholds. That's because the amounts above which benefits get taxed are fixed at those specific dollar amounts and are not indexed for inflation. As time goes by, more taxpayers will see their income levels climb above those thresholds, even as the purchasing power of their income stays stable or even falls due to inflation.

Social Security is an essential part of the financial security of millions of Americans, and many of them can ill-afford to lose any of their monthly benefits to the IRS. As long as the current tax rules remain in effect, though, you have to be aware of the danger of having your benefits taxed and take steps to protect as much of your hard-earned Social Security as you can from the grip of the government.

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