Stealth Tax on Social Security

As more retirees join the ranks of Social Security recipients, they’re discovering that they may not keep as much of their benefit checks as expected. Known as the “stealth tax,” Social Security benefit taxes quietly impact a growing number of retirees, reducing their income in a way that often catches them by surprise. This blog post explores how this stealth tax works, why more people are affected each year, and some strategies to mitigate its impact on your retirement.

What is the “Stealth Tax” on Social Security?


The so-called “stealth tax” refers to the taxes levied on Social Security benefits when retirees’ income surpasses certain thresholds. Originally, Social Security benefits weren’t taxed. However, as the number of retirees increased and life expectancy rose, the government introduced a tax on these benefits in the early 1980s as a way to generate revenue.

How Social Security’s Stealth Tax Works?


Depending on your income, up to 85% of your Social Security benefits can be taxed. For single filers with a combined income of over $25,000 or joint filers over $32,000, some Social Security benefits become subject to federal taxes. The combined income calculation includes adjusted gross income, nontaxable interest, and half of your Social Security benefits.

Understanding Provisional Income: The Key to the Stealth Tax


Provisional income includes more than just the income you receive from Social Security. It’s a combination of:
  • Gross income
  • Tax-free interest (like from municipal bonds)
  • 50% of your Social Security benefits
For example, if you have a gross income of $50,000 and receive $18,000 a year from Social Security, you’ll owe taxes on up to 85% of your Social Security income — that’s $15,300 of your $18,000 in benefits.

Rising Cost-of-Living Adjustments = More Taxed Benefits


Thanks to recent high COLAs, more retirees now find themselves subject to the 85% tax. In fact, if income thresholds had kept pace with inflation, the $25,000 limit for individuals would be around $73,000 today, and the $32,000 threshold for couples would be closer to $93,200. The lack of inflation adjustment means that each COLA increase effectively broadens the pool of Social Security recipients who owe taxes, even as their purchasing power stays the same.

Why are Retirees Paying Taxes on Social Security?


When Social Security was first introduced, it was entirely tax-free. But, federal tax rules require beneficiaries to pay taxes if their income exceeds certain thresholds. And here’s the catch: while Social Security benefits are adjusted each year through Cost-of-Living Adjustments (COLAs) to keep pace with inflation, the income thresholds for taxation haven’t changed since 1984. This mismatch means that every time a COLA is applied to benefits, more seniors are pushed into income brackets that trigger taxes on Social Security.

Why are More Retirees Being Impacted Each Year?


The thresholds triggering Social Security taxes were established decades ago and have never been adjusted for inflation. With the cost of living and average wages increasing over time, more people find themselves above these thresholds each year. What once was a higher income threshold is now considered middle income for many retirees, which expands the reach of this “stealth tax” as more retirees earn “too much” by today’s standards.

How the Stealth Tax Impacts Your Social Security Benefits?


Let’s break down how your benefits might be taxed under current rules:

Income Thresholds and Taxable Benefits:
  • Single filers with a combined income between $25,000 and $34,000 may see up to 50% of their Social Security benefits taxed. For incomes above $34,000, up to 85% of benefits can be taxed.
  • Joint filers with a combined income between $32,000 and $44,000 could be taxed on up to 50% of their benefits, and those with incomes above $44,000 could have up to 85% of their benefits taxed.

Impact on Overall Retirement Income:
  • If a significant portion of Social Security benefits goes toward federal income taxes, retirees may have to rely more on savings or other income sources, which may not be sustainable in the long run.
  • In states that tax Social Security as well (though fewer states do), the tax burden can be even greater.

Strategies to Minimize the Stealth Tax on Social Security


While Social Security taxes can be frustrating, there are ways to manage your taxable income and potentially reduce the impact of this tax.

1) Manage Withdrawals from Retirement Accounts:
Because withdrawals from traditional IRAs or 401(k)s count toward your combined income, strategically managing withdrawals can help you stay below tax thresholds. Consider withdrawing less from these accounts and using other income sources if possible.

2) Consider Roth Conversions:
Funds in Roth IRAs aren’t counted toward your combined income, so converting a portion of your traditional IRA to a Roth IRA before retirement could reduce your taxable income later. If you’re planning Roth conversions, try to complete them by age 63. This timing helps avoid additional costs, like higher Medicare premiums, which are determined by your income from the last two years.

3) Plan for Tax-Efficient Investments:
Investing in tax-efficient assets, such as tax-exempt municipal bonds, can help reduce the amount of taxable income that pushes you over Social Security thresholds.

4) Delay Social Security Benefits:
By delaying benefits until age 70, you’ll receive a higher monthly benefit, which may allow you to delay other withdrawals, keeping your income lower for a longer period. Additionally, delaying Social Security gives you more time to strategize with other retirement accounts.

5) Reduce Provisional Income: 
This can be challenging if you rely on all your income sources to fund your retirement. Cutting provisional income means lowering either your gross income, tax-free interest, or your Social Security benefits themselves — all tough asks when every dollar counts.

6) Convert Traditional Retirement Accounts to Roth IRAs: 
One potential solution is to convert 401(k) or traditional IRA funds into a Roth IRA. Withdrawals from Roth IRAs don’t count toward provisional income, meaning they won’t push you into higher tax brackets on your Social Security. Just be aware that converting to a Roth IRA is a taxable event, so it’s best done gradually to avoid jumping to a higher tax bracket.

Preparing for the Future of Social Security Taxes


With more retirees facing Social Security taxes each year, some hope for adjustments to the outdated income thresholds, especially since they haven’t kept up with inflation. Yet, with Social Security facing its own funding challenges, changes to the benefit tax structure remain uncertain. Planning ahead, managing your income sources, and seeking advice from financial advisors can help you navigate these stealth taxes and protect more of your hard-earned retirement income.

The Toll of “Double Taxation” on Retirees


Critics argue that these tax rules are particularly harsh on older Americans. The tax is viewed by many as a form of “double taxation,” since Social Security benefits were funded by payroll taxes paid over a lifetime of work. A survey by The Senior Citizens League showed that 58% of older taxpayers would like to see income thresholds adjusted, which would ensure that inflation doesn’t continue to erode the tax-free portion of their benefits.

Financial expert Jordan Gilberti calls it a “stealth tax” because many retirees don’t realize how these taxes impact them until they see the deduction firsthand. “People’s jaws would fall to the ground,” Gilberti told USA Today when explaining how widespread this impact is.

The Challenge of Changing the Rules


Adjusting these tax thresholds is a popular idea among retirees, but making legislative changes has proven difficult. Mary Johnson, a Social Security and Medicare policy analyst at The Senior Citizens League, points out that older Americans have not historically been included in discussions around Social Security reform. “When they’re considering changes to Social Security and Medicare, they’ve never, ever turned to senior constituents or advocates,” Johnson said.

Adding to the burden, retirees in a dozen states might also owe state taxes on Social Security income. States like Colorado, Connecticut, Kansas, and Utah, among others, have their own tax structures that may apply to Social Security.

Final Thoughts:
As Social Security taxes quietly impact more retirees, planning ahead is crucial. Whether you’re nearing retirement or already there, understanding the stealth tax on Social Security benefits can help you make smart choices to maximize your income. By staying informed and using strategies to manage your taxable income, you can protect a larger share of your Social Security benefits and enjoy a more financially secure retirement.