The Social Security program may be in long-term trouble, but its importance for current and future retirees is growing.
According to national pollster Gallup, a survey conducted in 2015 on retirees showed that 59% rely on Social Security to be a major source of income in retirement, with another 31% citing their benefits as a minor source of income. As for non-retirees, 36% expect Social Security income to represent a major source of their income -- the highest level since Gallup's poll began in 2001 -- with another 48% anticipating it'll be a minor source of monthly income. Without Social Security income, quite a few current and future retirees would struggle to make ends meet.
But Social Security is in trouble. Beginning in 2020, according to the latest Social Security Board of Trustees report, the program's cash inflow, including interest earned on its $2.8 trillion in spare cash, will turn into a cash outflow due to the increasing number of boomers leaving the workforce, a falling worker-to-beneficiary ratio, and lengthening life expectancies. By the year 2034, per the Trustees, the program will have used up the entirety of its spare cash, potentially leading to a 21% cut in benefits.
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However, this isn't the only concern for retirees. A majority of retirees will also pay federal tax on their Social Security benefits, which reduces what they get to keep.
In 1983, Congress enacted an amendment to the Social Security program allowing the Internal Revenue Service to tax up to 50% of the benefits of individuals earning more than $25,000 a year and couples with more than $32,000 in earned income. A second amendment was added in 1993 that further expanded what benefits were taxable. Up to 50% of a retirees' Social Security benefits become taxable with earned income of $25,000 to $31,999 for an individual, and $32,000 to $43,999 for joint filers. Earned income above these amounts would allow for up to 85% of a Social Security recipients' benefits to being taxed.
When these taxes were first rolled out in 1983, they were designed to only affect about 1 in 10 Social Security recipients. However, since the income thresholds haven't been adjusted for inflation over the past 33 years, more than half of all Social Security recipients now owe at least some tax on their Social Security benefits, based on data from The Senior Citizens League.
And yet, there's more!
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These 13 states tax Social Security benefits
In addition to the federal government collecting tax on Social Security benefits, 13 states tax Social Security benefits to a varying degree. As you'll see below, though some states offer very high income exemptions which should only affect a very small percentage of the population, four states, in particular, mirror the tax schedule of the federal government without exemptions. These four states could be considered among the least-friendly states for the purposes of Social Security taxation.
The four states that mirror the federal tax schedule for Social Security discussed above are:
- North Dakota
- West Virginia
The following nine states also tax Social Security benefits, but offer some varied degree of income exemptions along the way.
- Montana: Montana's income exemptions actually parallel the federal schedule at $25,000 for an individual and $32,000 for joint filers. However, what retirees wind up paying in Social Security taxes in Montana is lower than what they'll pay federally or in the four states mentioned above.
- Colorado: In Colorado, up to $20,000 in income for persons between ages 62 and 64, and $24,000 in income for those aged 65 and up, is exempted from taxation. More importantly, Social Security income not taxed by the federal government isn't added back in to a person's adjusted gross income (AGI) for state income tax purposes.
- New Mexico: In New Mexico, Social Security benefits are partially taxable. Persons under the age of 65 can claim a deduction of $2,500, with those aged 65 and up able to claim an $8,000 deduction. For seniors, the deduction limits are $28,500 in AGI for individuals and $51,000 in AGI for joint filers. The tax rate on Social Security benefits ranges from a low of 1.7% to as high as 4.9%.
- Utah: Utah offers a retirement credit of up to $450 per person for those over the age of 65 that can be used to offset any Social Security taxes paid within the state. If you're under the age of 65, you'll be offered a 6% tax credit on your taxable Social Security benefits.
- Nebraska: According to AARP's 2015 analysis of Nebraska, individual taxpayers whose AGI is below $43,000, and joint filers whose combined federal AGI is under $58,000, will be exempt from taxation. Nebraska also recently indexed its tax brackets for inflation, meaning simple cost-of-living increases won't move Social Security recipients into a higher tax bracket in subsequent years.
- Kansas: Most Social Security beneficiaries in Kansas are going to be able to avoid paying state tax on their benefits. The reason is that Kansas exempts taxing Social Security benefits on persons with AGIs below $75,000.
- Missouri: Missouri offers the heftiest exemptions among those states which do tax Social Security benefits. Individuals earning up to $85,000 in AGI, and married filers with up to $100,000 in AGI, are exempt. Furthermore, if you exceed the exemption you may still qualify for a partial exemption.
- Connecticut: Connecticut offers some pretty generous Social Security tax exemptions, but considering that its state also features the one of the highest annual incomes in the country, a higher exemption limit makes sense. Individuals can earn up to $50,000 in AGI, and married filers up to $60,000, and be exempted from paying Social Security taxes within the state.
- Rhode Island: Next to Missouri, the exemptions in Rhode Island are the second-highest in the country (of the 13 taxable states). Rhode Island exempts single filers with less than $80,000 in AGI, and couples with up to $100,000 in AGI, from paying tax on their Social Security benefits.
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As you can see from the differences above, where you retire matters. Choosing to retire in one of the 37 states that doesn't tax Social Security benefits can be just one small step in ensuring that you minimize what you'll hand back in taxes. To some extent, states like Missouri, Rhode Island, and Kansas offer generous exemption levels that most beneficiaries will fall under, meaning they could still be smart retirement options.
However, retirees considering any of the other states should give strong consideration to the consequences of what those extra taxes could do to their monthly or annual cash flow before making the move.