Social Security benefits can go a long way in retirement, especially if your savings fall short. But there’s one sneaky expense that can take a bite out of your monthly checks: taxes.
Even when you retire, it’s hard to avoid taxes. Your Social Security benefits can be subject to both state and federal income taxes, and if you’re not prepared for them, they can throw a wrench into your retirement plans.
Exactly how much tax will affect your benefits depends on your situation and not everyone will be subject to them. Here’s what you can expect.
Preparation for state taxes
Whether you owe state income tax on your benefits depends on where you live, but the good news is that 38 states don’t tax Social Security at all. So there is a good chance that you are already ready.
The 12 states that have tax benefits include Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah, Vermont and West Virginia.
But even among the states that tax Social Security, most have exemptions based on income or age.
Is Social Security Income Taxable by the IRS? Here’s what you may owe on your benefits
In Colorado, for example, Social Security benefits are exempt up to $24,000 when you reach age 65. Kansas also exempts Social Security if your adjusted gross income is below $75,000 per year. And Nebraska is slowly phasing out benefits taxes, with all Social Security exempt by 2025.
If you’re unsure whether you’ll owe state tax on your benefits, it’s best to check your state’s rules to see if you’re eligible for any exemptions.
Don’t forget about federal taxes
State taxes are only half of the equation, and regardless of where you live, you may also owe federal taxes on your benefits.
Your federal taxes are determined by a number called “provisional income.” Your provisional income is half of your annual Social Security benefit plus your adjusted gross income and any non-taxable interest.
So for example, let’s say you collect $20,000 a year in benefits and withdraw $30,000 a year from your 401(k). In this scenario, your provisional income would be $40,000 per year. Here’s how much of your benefits may be subject to federal taxes based on your provisional income:
Source: Social Security Administration
If these numbers seem low, that’s because they are. The income limits for federal taxes have not been updated since 1984, when Social Security first became taxable. As the general cost of living rises, more seniors will owe federal taxes on their benefits if these limits remain unchanged.
This is how you avoid tax on your benefits
It’s hard to avoid Uncle Sam, but there’s a loophole that can help you get out of federal taxes on your benefits: invest in a Roth retirement account.
Withdrawals from a Roth IRA or Roth 401(k) do not count toward your provisional income. If the majority of your savings are in this type of account, you can reduce your provisional income enough to lower or even eliminate federal taxes on your benefits.
So, for example, if you were to withdraw $30,000 per year from a 401(k) while collecting $20,000 per year from Social Security, your provisional income would be $40,000 per year and you would owe taxes on up to 85% of your benefit amount.
But say you were to withdraw the money from a Roth IRA instead, all other factors remain the same. Your provisional income would be only $10,000 per year and you would not be subject to federal taxes at all.
Taxes can be complex and confusing, but it pays to understand how they will affect your benefits. When you have an idea of what to expect when it comes to state and federal Social Security taxes, you can go into retirement as prepared as possible.
Several of your questions in the 2022 tax season have been answered
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