Jennie Phipps, a semiretired writer and editor, had once been married to a certified public accountant. When she retired, she thought she was well prepared for any taxes she might face.
Ms. Phipps, 72, said that her annual income consisted of money withdrawn from an individual retirement account, about $50,000 from Social Security and $20,000 from a pension. She also earns some money from part-time work. But when she first started drawing Social Security benefits, she got a shock: Federal income taxes were due on 85 percent of those benefits.
“It’s not that I didn’t know about the tax, but in my head I didn’t calculate it,” she said. “I’m always surprised at the end of the year by how much tax I owe.”
Ms. Phipps, of Punta Gorda, Fla., isn’t the only one who has been caught off guard.
“A lot of people who don’t work with a financial adviser are very surprised to find out that Social Security benefits can be taxable,” said Luis Rosa, a certified financial planner in Los Angeles. “Then they have to take more money out of their I.R.A.s to compensate for the difference, and it becomes a never-ending cycle of taking money out to pay taxes and then paying taxes on that money. It’s not good.”
Social Security benefits weren’t taxed at all until 1984. In 1993, Bill Clinton signed legislation that expanded tax thresholds, making up to 85 percent of benefits taxable for recipients with combined incomes of more than $34,000 ($44,000 for joint filers). Those who earn less could be subject to taxes on up to 50 percent of their benefits. Combined income consists of a filer’s adjusted gross income, untaxed interest (such as from municipal bonds) and half of one’s annual Social Security payments.
Over the past 39 years, both Social Security payments and federal income tax brackets have continually shifted upward to compensate for inflation — but the income thresholds that result in a retiree’s benefits being taxed have not. When the tax took effect in 1984, during the Reagan administration, it was estimated to affect about 10 percent of Social Security recipients. By 2022, 48 percent of recipients were paying tax on some of their benefits, and paid $48.6 billion that year, according to the Social Security Administration. Most states do not apply state income taxes to Social Security benefits.
“Because the cutoff isn’t benchmarked to inflation, more and more beneficiaries are subject to the tax,” said Anqi Chen, assistant director of savings research for the Center for Retirement Research at Boston College. One consolation is that even at higher income levels, some portions of benefits aren’t taxed at all, with the rest taxed at the filer’s ordinary tax rate, Ms. Chen said. That produces an average effective tax rate of about 6.6 percent, she said, “which is not nothing, but it’s also a small percentage.”
The result is that a single filer collecting the average $1,844.76 monthly benefit could be taxed on up to half of her Social Security benefits if her annual total earned income — from wages, a pension, withdrawals from taxable retirement accounts, interest payments, gambling winnings, or any other taxable source — was just below $14,000. Add another $9,000 of income, and that filer would face taxes on up to 85 percent of her benefits. For joint filers, the tipping point is about $9,900 to hit the 50 percent tax threshold, and it’s a bit less than $22,000 for the 85 percent threshold.
For a clearer picture of the tax liability that they could face, retirees can refer to the calculator called “Are My Social Security or Railroad Retirement Tier I Benefits Taxable?” on the I.R.S. website.
For example, imagine a single retiree with $1 million in combined qualified retirement accounts, such as I.R.A.s, and $500 in nontaxable interest who receives the $1,844.76 average monthly Social Security benefit. If she followed the standard advice to withdraw 4 percent of the balance of her accounts during 2022, she would pay taxes on $18,816 of her annual Social Security income.
Jeremy Shipp, a certified financial planner in Richmond, Va., said a majority of his retiree clients were likewise caught unaware that their Social Security benefits were taxable.
“People sometimes still manage their money as if they’re living in the Great Depression because that’s how their parents handled things,” Mr. Shipp said. “That speaks to the way financial mindsets are passed down through generations. Grandpa and Grandma and Mom and Dad never paid taxes on their benefits, so they’re very surprised.”
Avoiding the tax is possible, but it becomes harder once a Social Security recipient turns 73 and must start taking required minimum distributions from I.R.A.s and other tax-deferred accounts. The required distribution for a 73-year-old with $370,000 could be enough to activate the tax on 50 percent of her benefits. Federal workers receiving full pensions often don’t need any other income to hit the tax threshold, Mr. Shipp said, and the interest portions of annuities also are counted in the income calculation.
Mr. Shipp and other financial planners said that shifting income to postpone taking Social Security benefits while spending money from retirement accounts would be one approach to avoiding the benefit tax. Converting a traditional I.R.A. to a Roth I.R.A. could also work, because Roth withdrawals don’t count as taxable income (but that conversion requires paying taxes, too).
For homeowners, planners said, another strategy would be to leave any I.R.A.s or similar accounts untouched for heirs (if one can afford to) and use a reverse mortgage for income (though these mortgages are complicated and not for everyone). Proceeds from loans, like a reverse mortgage, a home-equity loan or line of credit, or a cash-out mortgage refinancing also provide income that isn’t included in the combined income calculation.
“Like any government program, there’s nothing simple about it,” Mr. Shipp said. “You almost need a 20-page manual to calculate what’s going to be taxable.”
Despite significant changes to retirement accounts in the Secure 2.0 Act, passed last year, there hasn’t been any effort to change the laws governing taxes on Social Security benefits. In fact, keeping income limits fixed was part of the original plan, according to the Social Security Administration, to shore up the Social Security Trust Fund against a potential shortfall. Taxes paid on Social Security benefits go to the fund, making up 4 percent of its 2022 income, according to the administration.
With or without any changes to the way Social Security benefits are counted, taxes in retirement can have a significant effect on how much money retirees can spend and how long their money lasts. The best approach is to make a retirement income plan that fully accounts for any potential tax bite.
“Normally, when we take taxes into our retirement planning it’s not a huge shock because you’ve planned for it, so you can have a little bit of control,” Mr. Rosa said. “You may need more money or to work a little longer if you’re going to be facing taxes. The key is knowing ahead of time.”
Knowing ahead of time wasn’t much comfort to Ms. Phipps. “I didn’t take Social Security until I turned 70, to maximize my benefits, and 85 percent of that is taxed. It’s no surprise, but it’s a chunk of tax,” she said.
For her 2023 tax return, however, that chunk will shrink somewhat.
“I’m getting married to a man whose taxable income isn’t huge,” Ms. Phipps said. “It makes being married and filing jointly very appealing.”