How Social Security Benefits are Taxed and Tips to Plan Ahead

Social Security is the foundation of the American retirement plan. It was not always meant to be that way, and it may not always stay that way, but for now, it is. In 2025, an average of 69 million Americans per month will receive a Social Security benefit, totaling roughly $1.6 trillion in benefits paid this year. Of those 69 million beneficiaries, 51.8 million are retired workers (7.2 million are disabled workers and the rest are dependents or survivors). With an average monthly retirement benefit of $1,931, Social Security represents 31% of the income of people over the age of 65, making it the largest source of retiree income.

The future of Social Security will be determined by simple math, inflows and outflows. Many current retirees worry if their benefits will be reduced or jeopardized during their lifetime. On the other end of the spectrum, Gen Z and millennials question if the program will even exist when they retire. The cause for concern, beyond political banter and media headlines, is the reality that Social Security is the second largest line item on the U.S. budget at $1.5 trillion annually, behind Medicare/Medicaid at $1.67 trillion and ahead of Net Interest on Debt of $1.02 trillion (Defense is fourth at $896 billion). The enormous cost is a result of changing population dynamics. In 1940, the ratio of Social Security Covered Workers paying tax to Beneficiaries collecting benefits was 159:1, in 1950 it was 17:1, in 1960 it was 5:1, and the trend continued to today where it is currently 3:1.

Before looking at how Social Security income may or may not be taxed in retirement, it is worth noting how ordinary income is taxed while working. Taxes under the Federal Insurance Contributions Act (FICA) are composed of old-age, survivors, and disability insurance taxes, collectively known as Social Security taxes. The current tax rate on earned income for Social Security is 6.2% for the employer and 6.2% for the employee, or 12.4% total. There is a wage base limit in 2025 of $176,100, after this threshold there is no longer a Social Security tax withholding. It is intended to be a self-financing program as most of its income comes from these payroll tax contributions (91.3%). Social Security revenues also come from federal income taxes on benefits (3.8%) and interest earned on trust fund reserves (5%). Over its 90-year history, Social Security has collected $27.75 trillion and paid out $24.96 trillion, leaving trust fund asset reserves of about $2.8 trillion. It is projected that these funds will be depleted by 2035, at which point tax revenues will be able to cover 83% of benefit payments.

The average retiree may not be overly concerned with these mechanics under the hood, per say. Most retirees just want to know how much their check will be and that it can be counted on. While politicians and economists debate increasing income taxes, raising the Social Security Normal Retirement Age, or adjusting the benefit formula, an immediate impact on retirees comes from taxing benefits. Taxing Social Security benefits is a way for Uncle Sam to recoup funds without technically reducing benefits or altering the program. Prior to 1984, Social Security benefits were received tax-free, but the 1983 Social Security Amendments changed this.

Taxation of Social Security benefits is determined by “combined income”, which consists of Adjusted Gross Income, plus any nontaxable interest, and half of Social Security income. For retirees filing Jointly, if their combined income is under $32,000, Social Security benefits are tax-free, between $32,000-$44,000 means up to 50% of benefits are taxable, and over $44,000 results in up to 85% of benefits being taxable. For Individual filers, the income thresholds are less than $25,000; between $25,000-$34,000; and over $34,000, respectively. These are the same income thresholds that were introduced in 1983, they have never been adjusted for inflation, which results in more people being subject to Social Security taxation every year. Additionally, 11 states tax Social Security benefits based on their own formulas.

Tips to Reduce Taxation of Your Social Security Benefits 

1. If you anticipate a big one-time event, such as the sale of a business, structuring an installment sale over several years could evenly distribute income over an extended period to stay in a lower tax bracket versus an all-cash transaction.
2. Consider deferring collecting Social Security benefits to the maximum of age 70 if you are still working.
3. Use Roth retirement accounts for tax arbitrage. Withdrawals from pretax retirement accounts such as Traditional IRAs, 401(k)s, etc. are generally included in federal taxable income. Coordinating qualified distributions from Roth accounts alongside pretax accounts may be able to keep you in a lower tax bracket. People still working can consider Roth retirement contributions to provide such future tax flexibility, whereas those who are retired but not yet collecting Social Security could still consider a Roth conversion.
4. Consider using non-retirement assets to defer taxable IRA distributions as needed. Cash values in life insurance may be able to be withdrawn or leveraged as a source of nontaxable income.
5. Be mindful of your taxable investment accounts by avoiding short-term capital gains that may be added to taxable income, whereas investments held for more than one year can receive preferential long-term capital gains treatment. Tax-loss harvesting can also be used to offset capital gains and capital losses.
6. For tax filers who itemize, consider charitable contributions to offset taxes. Retirees can also make charitable gifts directly from their IRA with a qualified charitable contribution (QCD). This does not provide a tax deduction, but it can avoid a taxable distribution and count as part of a required minimum distribution (RMD).

The future taxation of Social Security benefits is as uncertain as the system itself. Americans have watched benefits that were tax-free for nearly 50 years become taxable in 1984, further taxed in 1993, and now President Donald Trump is promising a return to exempting Social Security benefits from federal taxation. Only time will tell, but both workers and retirees can still prepare for the unexpected by considering the tips above.

This article is intended for the general public to potentially assist in planning for the future. This should not be considered investment advice. Readers should consult their own financial professionals, legal, and tax advisors to discuss their specific situation.

Written by Bryan M. Kuderna.
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