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Demystifying Social Security Taxation | Exploring the Double-Taxation Debate and State-Level Implications



Demystifying Social Security Taxation | Exploring the Double-Taxation Debate and State-Level Implications

Demystifying Social Security Taxation | Exploring the Double-Taxation Debate and State-Level Implications. Social Security benefits play a critical role in the financial stability of many American retirees. Gallup surveys spanning over two decades reveal that a substantial percentage, between 80% and 90%, of retirees rely on these benefits to cover a portion of their monthly expenses. Moreover, the Center on Budget and Policy Priorities reports that no other program has lifted as many people above the federal poverty line as Social Security.

Demystifying Social Security Taxation | Exploring the Double-Taxation Debate and State-Level Implications

However, the taxation of Social Security benefits remains a contentious issue, with many retirees objecting to it. A recent informal poll conducted by The Senior Citizens League found that a staggering 94% of respondents believe Social Security benefits should not be subject to taxation. The crux of this discontent revolves around the notion that taxing these benefits constitutes double taxation, as earned income is already taxed during one’s working years before being taxed again during retirement.

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The Dual Nature of Taxation on Social Security Benefits

So, are Social Security benefits truly subject to double taxation? The answer is both yes and no, contingent on your income level and place of residence.

Before delving into the intricacies of double taxation, it’s essential to comprehend how Social Security funding works. In 2022, the Social Security program accrued approximately $1.22 trillion in revenue from three primary sources:

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  1. Payroll tax ($1.11 trillion)
  2. Net interest ($66.4 billion)
  3. Taxation of benefits ($48.6 billion)

The payroll tax, a 12.4% levy, is applicable to all earned income between $0.01 and $160,200 (as of 2023), encompassing 94% of workers who contribute a portion of every dollar they earn. Wages and salaries account for about 90% of the funds collected by Social Security.

The $66.4 billion in net interest represents the interest accrued on special-issue bonds and certificates of indebtedness. These investments, mandated by law, have swelled Social Security’s asset reserves to over $2.8 trillion.

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The third revenue source is the taxation of benefits. In 1983, the Amendments of 1983 were enacted, allowing up to 50% of an individual’s Social Security benefit to be subject to federal ordinary income tax rates if their provisional income exceeded $25,000 (or $32,000 for married couples filing jointly). A second tier of taxation was introduced in 1993, exposing up to 85% of benefits to federal taxation for specific income thresholds. Importantly, these thresholds have not been adjusted for inflation, resulting in more retirees being affected by this tax over time.

Navigating Double Taxation on Social Security Benefits

Now that the funding mechanism of Social Security is clear, let’s address the core question: Is taxing Social Security benefits a form of double taxation?

For the majority of Social Security recipients, the answer is no. According to the Social Security Administration, 56% of beneficiaries will owe some level of tax on their benefits, leaving 44% untaxed.

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It’s crucial to recognize that the dollars received as benefits do not directly correlate with the dollars initially contributed through the payroll tax. Today’s workers fund the benefits for current retirees, and future generations will support those who are currently working. Therefore, the funds you receive in retirement are not being double-taxed.

Moreover, it’s impossible to trace the precise origin of Social Security dollars received, as they can come from various sources, including payroll tax, interest income, and taxation of benefits. The latter does not originate from taxation itself.

Double Taxation at the State Level

However, double taxation on Social Security benefits can occur at the state level. Out of the 50 states, 38 do not tax Social Security benefits. Yet, if you reside in one of the 12 states that do tax these benefits and earn above their prescribed income thresholds, double taxation may apply. In such cases, you’ll be taxed both federally and at the state level on the same Social Security income.

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The 12 states currently taxing Social Security benefits above specific adjusted gross income (AGI) thresholds include:

  • Colorado
  • Connecticut
  • Kansas
  • Minnesota
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • Rhode Island
  • Utah
  • Vermont
  • West Virginia
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The good news is that these states often set relatively high income thresholds, typically ranging from $45,000 to $85,000 in AGI for single filers. Some states have even increased these thresholds in recent years, offering relief to retirees subject to this form of double taxation.

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