Out of the 40% of people who pay taxes on their social security benefits, as many as 36.5 million are at risk of double taxation. Moreover, up to 85% of these benefits can be subjected to taxes. According to current Internal Revenue Service (IRS) rules, individual filers having combined incomes of more than $34,000, or married couples filing jointly with a combined income of more than $44,000, are subject to the maximum cut. 2023’s record-breaking 8.7% Cost Of Living Adjustment (COLA) has further pushed individuals into a higher tax bracket, notes CNBC.
In addition, since income tax thresholds haven’t been adjusted for inflation since 1984, taxpayers are now witnessing some serious tax hikes. David Freitag, a financial planning consultant and Social Security expert at MassMutual, calls these hikes a "stealth tax."
The 8.7% COLA adjustment exposing seniors to higher tax brackets has erased any gains the COLA was primarily supposed to deliver. According to Congressional Budget Office, the percentage of all tax returns with taxable Social Security benefits will increase to more than 50% by 2046.
As of 2017, the percentage stood at 33%, growing from 7.4% in 1999. Provided the income thresholds for social security are indexed to inflation, fewer beneficiaries would owe taxes. For instance, the first thresholds of $25,000 for individuals and $32,000 for joint filers would be $73,000 and $32,000, respectively.
Inflation reaching a decades-high level of 8.5% in 2022 has further increased the number of Americans raiding into their retirement funds. Fidelity reports that the number of individuals taking hardship withdrawals from their 401(k)s has increased from 1.9% in 2021 to 2.4% in 2022.
These dips have been boosting their incomes, increasing their likelihood of paying taxes on social security. While these thresholds strongly need to be adjusted for inflation, these taxes generate a lot of revenue for the government. As of 2023, social security taxes are expected to bring in $48.8 billion in revenues.
Moreover, social security fund reserves are likely to be depleted by 2033, making changes to the income thresholds seem like a distant reality. These funds are also witnessing a worsening impact due to inflation, with forecasts on economic output and productivity dropping by 3%. 11 states in the US have their own tax on social security income as well, leaving retirees with little behind.
Minimizing Retirement Income Taxes
While social security taxes cannot be avoided altogether, several strategies can be employed to help keep them minimized.
Staying below income tax thresholds
If the sum of your adjusted gross income, non-taxable interest, and half of the social security exceeds $25,000 individually or $32,000 as a married couple, you will need to pay 50% income tax on your benefits. Similarly, incomes topping $34,000 individually or $44,000 as a couple are liable to 85% of taxes. Retirees can try to stay below these thresholds in order to lower the percentage being levied on their benefits.
Consider IRA Withdrawals before Social Security Signup
Many companies offer Individual Retirement Accounts (IRAs) to help retirees with their savings, such as The Charles Schwab Corporation (NYSE:SCHW) and Interactive Brokers Group, Inc. (NASDAQ:IBKR). Individuals can consider taking IRA withdrawals from their respective accounts before signing up for social security. By doing this, it will keep combined income levels low and also allow them to wait until retirement age to avail the full benefits of social security. Receiving benefits early can reduce benefits by a small percentage for each month before the full retirement age.
Save in Roth IRAs
Roth IRAs are special individual retirement accounts in which taxes are paid on contributions, making all future contributions tax-free. Retirees can open Roth IRAs at The Charles Schwab Corporation (NYSE:SCHW) , Interactive Brokers Group, Inc. (NASDAQ:IBKR), Fidelity Investments, or other investment firms of their liking. This way, money coming from Roth IRAs will not count in combined income, minimizing taxes on social security payments. It must be noted that eligibility to open Roth IRAs depends largely on Modified Adjusted Gross Income, and not everyone is eligible to open this account.
Set up Withholding Taxes
Social Security tax payments can either be made quarterly to the IRS or withheld from monthly payments. 7%, 10%, 12%, or 22% of monthly benefits can be withheld for taxes, seemingly more convenient than taxes payment every quarter.
Consider Financial Advice
Individuals who wish to maximize their retirement savings and minimize taxes on social security can also take financial advice from their respective investment firms. The Charles Schwab Corporation (NYSE:SCHW), Interactive Brokers Group, Inc. (NASDAQ:IBKR), Fidelity Investments, and other firms have financial tools, resources, and ample knowledge to help guide seniors to a secure future.
Factor in State Taxes
While many states don’t tax social security income, 11 of the states do. These are Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah and Vermont. Similarly, some states tax pension income while others don’t. Considering the possibility of benefits taxation is important before planning to retire in any of the states.
15 States That Don't Tax Social Security Or Pensions
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Methodology
In order to choose 15 states that don’t tax social security or pensions, we listed out all the states that don’t tax social security or pensions. Next, we ranked the states based on their Cost of Living data, gathered from Missouri Economic Research and Information Center.
Choosing states with the lowest cost of living index can be beneficial as retirees can lose out more money due to higher cost of living regardless of no social security or pension taxes in a given state.
Without further ado, here are the 15 states that don’t tax social security:
15. Hawaii
Cost of Living Index: 184.0
Hawaii is a moderately tax friendly state that exempts only some kind of retirement incomes such as public pension income and social security benefits. However, retirement savings accounts and private pensions are fully taxed in the state. A cost of living index of 184 implies that living expenses in Hawaii are 84% above the national average. 90% of food and other items of necessity are imported, making grocery expensive as well. Experts recommend maintaining a 4% withdrawal rate from retirement savings in order to last them through the retirement period.
14. Alaska
Cost of Living Index: 126.6
Alaska is a very tax-friendly state with no taxes on social security retirement benefits or pension payments. It is also one of five states with no sales tax. There are no estate or inheritance taxes either. However, a sales tax as high as 7.5% can be levied by localities. Retirees aged 65 and older are also exempt from paying municipal taxes on the first $150,000 of assessed value of their property. Alaska is also one of the most expensive states to live in. Retirees saving on retirement income taxes may not be able to save more due to the high cost of living.
13. New Hampshire
Cost of Living Index: 116.1
Retirees in New Hampshire enjoy zero taxation on social security income, public and private pension income, and also withdrawals from retirement accounts. Seniors can also capitalize on the state’s non-existent sales, estate and inheritance taxes. However, a potential drawback of living in this state is its property taxes are the 4th highest at 1.77% on average. This means that typical homeowners in the state have to pay more than $6,097 in property taxes annually, twice as much as the national average.
12. Washington
Cost of Living Index: 114.2
Another popular choice on the West Coast for retirees is Washington. Seniors love this state not only for the natural wonders but also because of the state’s friendly tax system. The state has no income tax, and retirees can enjoy working part-time, tax-free. The only taxes that must be considered before moving are its high sales taxes at 6.5%. Property taxes are also moderate at 1%. Regardless, cost of living is 14% higher than the national average. The state also has its own estate tax that has a fairly low exemption.
11. Nevada
Cost of Living Index: 103.2
Another tax friendly state that does not tax socials security benefits or pensions is Nevada. The state also boats relatively low property taxes at merely 0.48% on average. Home to plenty of golf courses and casinos, retirees can enjoy lots of recreational activities across the state. Sun shines for 220 to 300 days, and the climate is semi-arid with light snow or rainfall. Cost of living in the state is slightly above the national average (3%), and residents need at least $30,000 annually to live comfortably. Other tax benefits in the state include no estate or inheritance taxes,
10. Florida
Cost of Living Index: 102.8
The sunshine state of Florida isn’t only popular for its tropical lifestyle. Rather, it’s tax-friendly system is a big plus for retirees. The state boasts a no income tax, making all sorts of retirement income tax-free. Green fairways and warm winters, beautiful beaches, and an overall pleasant weather makes this state a popular choice for retirees. What’s pleasantly surprising about this state is that sales and property taxes are very close to national averages, unlike other states that keep them high in order to make up for zero retirement income taxes. Lastly, cost of living in the state is slightly higher than the national average.
9. Pennsylvania
Cost of Living Index: 98.2
Another ideal state for retirees to settle in is Pennsylvania. With no social security income tax and no taxes on withdrawals from retirement accounts, this state is worth considering when retiring. Pension income is also exempt for seniors aged 59.5 and above. The state is slightly less expensive than Idaho, with an average cost of living amounting to $49,040 on average. Moreover, sales taxes stand at 6% on average while property taxes are high at 1.58% on average. Those who receive inheritances must be aware that there is an inheritance tax rate levied based on relationship of the inheritor to the decedent.
8. South Dakota
Cost of Living Index: 94.5
South Dakota is extremely tax-friendly towards retirees, having no social security retirement benefits, taxation, or taxes on retirement account withdrawals. Sales taxes are also low at 4.5%. However, property taxes are a little high at 1.08%. Regardless, other advantages help seniors offset these costs. The overall cost of living is 6% lower than the national average.
7. Illinois
Cost of Living Index:92.6
Nearly all types of retirement incomes are exempted from taxation in Illinois. These include social security, income from retirement accounts, and pension incomes. However, many retirees may not consider Illinois as the best option considering its extremely high property and sales tax rates. The average property tax rate is the second-highest at 2.08%, while the sales tax rate is 6.25%.
6. Texas
Cost of Living Index:92.5
Another state that doesn’t tax social security retirement benefits and other types of retirement incomes is Texas. However, property taxes and sales taxes are high at 1.6% and 6.25%, respectively but it still stands as a tax-friendly state, as retirees who are not working will not be subjected to the 4.95% flat income tax rate. Overall, the cost of living is 8% less than the national average. Housing is 20% lower, utilities 7%, and food 2%.
