The Social Security Tax Surprise Waiting for Middle-Income Retirees

After paying into Social Security for decades, retirees finally get the opportunity to tap into their benefits as early as age 62. But those same retirees may end up with higher tax bills than expected for those benefits if they are receiving income from other sources, including pensions and individual retirement account (IRA) withdrawals.

Social Security isn’t tax-free, and knowing what can trigger higher tax rates is an important step to preserving your finances.

Why Social Security taxes catch retirees off guard

Up to 85% of Social Security benefits can be subject to federal income tax if a retiree’s income crosses certain thresholds. Benefits start to become taxable once your income exceeds $25,000 for single filers and $32,000 for married couples.

If your income is between $25,000 and $34,000 as an individual taxpayer or $32,000 and $44,000 for those married filing jointly, up to 50% of your benefits may be taxed. Once you cross $34,000 as a single filer and $44,000 as a married couple filing jointly, up to 85% of your benefits can be taxable. That doesn’t mean you get an 85% tax rate. It just means 85% of your benefit amount is taxable at your current tax rate.

Retirees who calculate if Social Security can cover their living expenses should consider taxes on their benefits instead of looking just at the benefit’s face value. The calculation to determine how much you’ll have to pay in federal taxes on your benefits includes half of your Social Security income.

What counts as income?

Income isn’t just your paycheck. Interest from certificates of deposit (CDs), monthly pension payments and withdrawals from traditional 401(k) or traditional IRA plans count as ordinary income. All of those income sources can push you into a higher tax bracket and make a higher percentage of your Social Security benefits eligible for taxation.

The thresholds for determining what percentage of your benefits are eligible for taxation do not get adjusted for inflation each year. That means as costs rise and people have to withdraw more money from traditional retirement plans, their taxes on Social Security benefits can increase over time.

What retirees can do before tax season

It’s better to know the reality of this situation and prepare accordingly than get caught by surprise. Delaying Social Security benefits and withdrawing from traditional retirement plans can help spread taxes over a long stretch while increasing your Social Security benefits.

You can also use Roth IRA withdrawals to minimize the tax impact of accessing your nest egg. Qualified withdrawals from Roth plans are not subject to taxes. If you are still working, converting a portion of your traditional retirement plans to a Roth plan can spread the tax impact and leave you better prepared for required minimum distributions (RMDs). You only have to take out RMDs for traditional retirement plans, and they can result in higher tax rates. RMDs generally do not apply to Roth plans.

Retirees also have to assess state and local taxes, which vary based on their location. Some states do not collect any income taxes, while other states have lower tax rates for Social Security benefits.