Many retirees are surprised to learn that their Social Security benefits can be subject to federal income tax.
The IRS determines the taxable portion based on what it calls your “combined income.”
Understanding this formula can make a meaningful difference in how much income you keep during your post-career years.
How Social Security became taxable
The taxation of Social Security benefits was introduced through a federal law created in 1983, which permitted up to 50% of benefits to be subject to federal income tax, a change outlined by the Social Security Administration.
Another law created in 1993 allowed up to 85% of benefits to be taxed.
This system remains the standard today.
How combined income determines your tax liability
Your combined income is calculated by adding all three of the following together:
- Your adjusted gross income (which you can find on your latest federal income tax return)
- Any nontaxable interest you receive (such as interest earned on municipal bonds)
- Half of your Social Security benefits
Based on your combined income, you’ll fall into one of three categories:
- No taxation. If your combined income falls below $25,000 for individual filers or $32,000 for joint filers, you won’t owe any federal taxes on your Social Security benefits. According to the Social Security Administration, about half of all beneficiaries fall into this category.
- Up to 50% taxed. When your combined income is between $25,000 and $34,000 for single filers or between $32,000 and $44,000 for joint filers, up to 50% of your benefits may be taxable.
- Up to 85% taxed. If your combined income exceeds $34,000 for individual filers or $44,000 for joint filers, up to 85% of your Social Security benefits could be subject to federal income tax.
Who bears the biggest tax burden?
On average, beneficiaries owe taxes on about 7% of their Social Security benefits, but the impact varies dramatically across income levels. Analysis by the Center on Budget and Policy Priorities shows:
- Lower income retirees (those in the bottom 40% of the income distribution) typically owe taxes on 1% or less of their benefits.
- Higher income retirees (those in the top 20%) pay tax on around 20% of their benefits.
Social Security taxation policies were intended to help strengthen the program’s long-term financial stability, and the system was structured so that higher-income beneficiaries would contribute more.
Smart planning can reduce your Social Security tax bite
Perhaps the biggest challenge for retirees is that the combined income thresholds have remained unchanged since they were established. In other words, they have never been adjusted for inflation. So, as incomes rise over time, more Social Security recipients find their benefits subject to taxation.
Many retirees are unaware that withdrawals from traditional IRAs and 401(k)s count toward their combined income, which can in turn increase the portion of their Social Security benefits that are taxable.
To learn more about such strategies, check out “7 Ways to Avoid Paying Taxes on Your Social Security Income.”
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