Retirees Enjoy These Key Benefits Come Tax Time

by Mark Miller / Reuters

Tax day is April 18th this year, and it will be an unpleasant day for millions of American working households. But cheer up: your tax situation likely will lighten up a bit when you retire.

The Internal Revenue Service takes it easy when it comes to taxation of Social Security, and many retirees drop into lower tax brackets that help soften the tax bite taken from pensions, IRAs dividends and capital gains. Many states exempt Social Security from taxation, and a handful exempt all retirement income.

Taxable income does tend to fall in retirement, when wage income stops. Households headed by individuals over age 65 had an average adjusted gross income (AGI) of $69,000 in 2013, compared with $88,000 for households age 55 to 65, according to analysis of Internal Revenue Service data by the Tax Foundation.

In 2013, about 9.7% of households were over age 65 and paid neither federal income taxes nor payroll taxes, according to the Urban-Brookings Tax Policy Center. They are part of the 43.3% of all households that had no income tax liability that year - mostly because they had income too low, or could offset income with deductions and personal exemptions.

All told, 35% of seniors' taxable income in 2013 came from traditional pensions, 401(k)s and IRA withdrawals, according to IRS data. Wages are the second highest category of taxable income - 23% - while Social Security accounts for 13%. The remainder of taxable income received by seniors is a mix of qualified dividends, taxable interest and capital gains.

Taxpayers in the 15% bracket or lower do not pay taxes on long-term capital gains and qualified dividends. This year, that protects single filers with taxable incomes up to $37,650 and joint filers earning up to $75,300.

"That means, for example, that a retired couple with $20,000 of Social Security and $30,000 of qualified dividends owe no income tax on their 2015 tax return," says Roberton Williams, the center's Sol Price fellow.

Seniors also tend to make greater use of itemized deductions than younger taxpayers, notes Scott Greenberg, an analyst with the Tax Foundation.

"Taxpayers 65 and older are more likely than average to itemize deductions, and report higher charitable deductions as a percentage of their income than other age groups," Greenberg says.

Social Security income is subject to taxation, but 15% of benefits are exempt. And taxes kick in only if your income is above $25,000 (single filers) or $34,000 (joint filers). As a consequence, only about half of Social Security beneficiaries paid taxes on their benefits in 2014, according to the Congressional Budget Office (CBO).

Formula for Filers

Here is how the formula works. First, you determine a figure Social Security calls "combined income" - also sometimes called "provisional income." This is equal to your adjusted gross income plus nontaxable interest plus 50% of your Social Security.

Single filers with combined income from $25,000 to $34,000 pay income tax on up to 50% of benefits; for those with income above $34,000, up to 85% of benefits are taxable. Joint filers with combined income from $32,000 to $44,000 pay income tax on 50% of benefits; income above $44,000 to 85% is taxable.

Beneficiaries receive IRS Form SSA-1099 from the IRS during tax season, which reports the net benefit subject to tax (after Part B Medicare premiums have been subtracted).

Income is reported on the 1040 or 1040a forms. Form 1040EZ cannot be used. The popular tax-filing software programs also have the capacity to handle Social Security income. You can also ask the Social Security Administration to withhold taxes when you file for benefits at rates of 7%, 10%, 15% or 25%.

Meanwhile, states are all over the map when it comes to their policies on taxing retirement income.

Twenty-nine states (including the District of Columbia) that have a broad-based income tax exempt all Social Security from tax, according to the Institute on Taxation and Economic Policy (ITEP). Seven states tax some Social Security benefits but provide an exemption that is more generous than what is available at the federal level. Six states tax Social Security benefits using the federal formula.

And a handful of states that have a broad-based income tax (Illinois, Mississippi and Pennsylvania) exempt all retirement income from taxation. Meanwhile, 36 states with an income tax allow some exemption for private or public pension benefits.

If you are uncertain how your state treats retiree income, check out ITEP's state-by-state guide to tax policy.