Taxes in Retirement: How are Social Security Benefits Taxed

You’ve worked hard, paid into Social Security, and now it’s time to enjoy your well-earned benefits in retirement.  But wait—are they really tax-free?  Well, like many things in life, it depends!  Whether or not your benefits will be subject to federal income taxes depends on a specific formula.  This formula includes many retirement income sources and determines the taxable portion of your benefits according to your filing status.  Let’s break down the specifics of how this applies to you, ways to reduce your tax bill and how this works at the state level.

What Determines If Your Social Security Benefits Are Taxed?

While you were working, you were likely used to receiving a W2 that reported the total taxable income from your employer.  That entry on your tax return was 100% taxable and so relatively straightforward.  Social Security benefits are unique- they are never 100% taxable and can range from 0% up to 85% taxable.  Given this wide range, it’s important to understand how the amount of benefit that is taxable is calculated. 

The formula to determine the taxable amount of Social Security benefits on your Federal income taxes calculates what is often called your combined or provisional income.  This combined income is found by the following steps:

• Take your gross income (total amount of money you make such as retirement distributions, pensions, etc.) not including your Social Security benefits. 
• Add back any tax-free interest you received such as interest from a municipal bond. 
• Calculate 50% of your Social Security benefit and add that to the previous total.  Now you’ve got your combined income. 

Let’s say your gross income was $25,000 and you earned $2,000 in municipal bond interest.  Adding those amounts gives you $27,000.  Now, let’s assume you receive $28,000 in Social Security benefits.  Divide that in half to reach $14,000.  Finally, add $27,000 and $14,000 and your combined income is $41,000. 

But what does your combined income number mean?  The chart below shows the level of Social Security taxation for various combined income thresholds whether you are a single tax filer or married filing jointly.  As you can see from our prior example, if this person was filing a single return, the taxable portion of their benefits would be 85%.  However, if this person was completing a married filing joint return, then it would only be up to 50% of benefits.

How Much of Your Social Security Benefits May Be Taxed?

You might be asking, what does 50% or 85% Social Security taxation really mean?  Will I be taxed at an 85% rate on my benefits?!  The good news is that this percentage is simply the amount of your benefit that will be included in the Federal tax calculation- not your actual tax rate.  So, in our prior example, a single tax filer would have included 85% of the benefit as taxable (or $23,800) and a married filing jointly filer would only have needed to include 50% of the benefit (or $14,000).  You do not need to calculate your own taxable portion of Social Security benefits every year.  Instead, you will receive a form SSA-1099 prior to filing your taxes that will detail your total benefit, taxable portion and any Federal tax withholding.  

The rate at which the taxable portion of your Social Security income will be taxed depends on your other income sources and where you fall in the Federal tax brackets.  Your marginal tax rate is the tax rate applied to the last dollar of your taxable income and represents the highest tax rate applied to your income.  Those taxpayers who fall in the 10%, 12% and 22% marginal brackets are most dramatically affected by the inclusion of taxable Social Security benefits.  For them, every additional dollar of retirement income (i.e. additional IRA distributions), drags more Social Security dollars into the tax calculation.  This can lead to extremely high marginal rates of up to 40.7%.    

Strategies to Reduce Taxes on Social Security

Given the large impact that other income sources can have on the taxable portion of benefits and marginal tax rates, it can be highly beneficial to consider strategies that may help reduce this tax burden. 

Delay Claiming Benefits

Social Security offers an 8% raise per year for delaying benefits until age 70.  Delaying benefits not only increases the benefit amount but also allows for more years of lower income where tax savings strategies like Roth conversions can be used.  Click here to read more about SS claiming strategies for couples.

Roth Conversions

Roth conversions are where money in a pre-tax retirement account is converted into Roth account money by paying the taxes now.  Some folks in early retirement may be able to pay taxes on the conversion at a lower rate than when they are collecting Social Security benefits and subject to required minimum distributions (RMDs).  This strategy can help lower eventual RMDs and therefore the amount of Social Security benefit that is being taxed down the road.

Creating Tax Flexibility

As folks approach retirement age, it can be helpful to build up various account types beyond pre-tax IRAs and 401ks such as taxable brokerage accounts and Roth accounts.  This allows for options in retirement and tax flexibility for distributions.  For example, if a couple needs an additional $30k to buy a car in one year, rather than taking that money as an IRA distribution that would be fully taxable they can instead take the funds from their non-qualified brokerage account.  This reduces that year’s taxable income and potentially saves on total Social Security benefits being taxed.  Click here to read more on how to pay yourself in retirement.  

Charitable Planning

For those who are charitably inclined, finding tax-smart ways to complete your regular giving can greatly reduce your overall taxable income which in turn can reduce Social Security benefit taxation.  Some strategies relevant for those approaching retirement age are to consider Qualified Charitable Distributions (QCDs) from your IRA and potentially opening a Donor Advised Fund for bunched giving.  Click here to read more on how to make the most of your charitable giving.

State Taxes on Social Security- Do you Need to Worry?

We’ve talked quite a bit about how the Federal government taxes benefits, so how does this apply for states that collect income tax?  In short, some states tax Social Security benefits, while others don’t.  It’s important to review the rules for your specific state and consider consulting with a tax professional or financial advisor to fully understand how your benefits will be taxed. 

Most of our clients live in Minnesota, so we will focus our review of state taxation around Minnesota tax law.  Minnesota passed legislation in 2023 that allowed for a greatly expanded Social Security benefits subtraction.  Taxpayers who have adjusted gross income (AGI) below $100,000 for MFJ and $78,000 for single filers are allowed to subtract their entire Social Security benefit from the tax calculation.  This subtraction is phased out by 10% for each $4,000 of AGI over these thresholds.  Therefore, strategies aimed at reducing taxable income for Minnesotans approaching retirement age can make a big impact in total lifetime dollars lost to taxes. 

Conclusion: Planning Ahead to Keep More of your Benefits

As you can see, understanding how Social Security benefits are taxed (or not) allows you to plan for tax-smart retirement income and reduce your total taxes paid in retirement.  This can help you to retire earlier, enjoy doing more in your retirement and give more to the people and causes important to you.  If you’d like to see how your current retirement accounts and benefits might impact your taxes, reach out to schedule an initial call.  Bottom of Form

Liz Alf is the Principal of Clerestory Advisors and fee-only CERTIFIED FINANCIAL PLANNERTM located in Minneapolis, MN.  She is a member of the National Association of Personal Financial Advisors (NAPFA), the Fee Only Network and Wealthtender.  She enjoys serving clients with on-going financial planning and investment management services.