Most States Leave Social Security Untaxed, but the IRS Can Still Tax as Much as 85% of It

You paid into Social Security with every paycheck, but receiving those benefits tax-free in retirement is not guaranteed. Under a little-known federal rule, a sizable share of your monthly payment could still go back to the IRS.

Every paycheck contributes to Social Security through payroll taxes. There is an annual wage cap, but for most moderate earners, some of each paycheck is directed to the program.

That may make it seem as if your retirement benefits should automatically be tax-free. In reality, that is not always the case.

Although most states do not tax Social Security, eight states do. And even if you live in one of the 42 states that do not, federal taxes can still apply to up to 85% of your benefits because of a longstanding rule.

When Social Security benefits become taxable

Most of Social Security’s funding comes from payroll taxes, but taxes on benefits also help support the program.

Whether you owe federal tax on Social Security depends on your provisional income.

Provisional income is calculated by adding your adjusted gross income, tax-exempt interest, and 50% of your annual Social Security benefits. If that total is below $25,000 for a single filer or below $32,000 for a married couple filing jointly, none of your benefits should be taxed.

Once your provisional income rises above those levels, part of your benefits may become taxable. For single filers with provisional income between $25,000 and $34,000, or joint filers with provisional income between $32,000 and $44,000, up to 50% of benefits can be taxed.

If your provisional income exceeds those ranges, as much as 85% of your Social Security benefits may be subject to federal tax. That does not mean you lose 85% of your checks to taxes; it means up to that share is taxed at your ordinary income tax rate.

For example, if you are single, have provisional income of $40,000, and receive $2,000 a month in Social Security, up to 85% of that benefit, or $1,700, could be taxable. At a 22% income tax rate, that could translate to as much as $374 a month in taxes on Social Security.

Ways to reduce the tax burden

If your retirement income is relatively high, paying federal tax on Social Security may be hard to avoid. Even so, you may still be able to lower your overall tax bill.

One strategy is to keep at least part of your retirement money in a Roth IRA. If you are close to retirement and still have funds in a traditional retirement account, a Roth conversion may also be worth considering.

Selling investments at a loss in a taxable brokerage account can help offset taxes, and careful use of deductions may also reduce what you owe.

Even with careful planning, some retirees will still owe tax on Social Security benefits. That is not necessarily a mistake or a failure in planning.

In many cases, it simply means income is too high to avoid taxation entirely. Planning ahead, however, can make those taxes more manageable.