How Will Social Security Tax Affect Your Retirement?

September 19, 2024 Ron Sanders

Understanding how Social Security and taxes work together is crucial for your financial planning, especially as you approach retirement. Many people assume that Social Security benefits are tax-free. But in reality, depending on your overall income, a portion of your benefits could be subject to taxes. Let’s break down how Social Security taxes work, the different factors that could reduce your benefits, and how you can plan ahead to reduce your tax burden.

What Is the Social Security Tax?

Social Security is a federal program established in 1935, providing monthly financial benefits to retirees, survivors of deceased workers, and disabled workers. The program is funded through the Social Security tax, which is applied to wages. Employers and employees both contribute to this tax, while self-employed individuals cover the full amount.

The Social Security tax for employees is part of the Federal Insurance Contributions Act (FICA), and self-employed individuals pay it under the Self-Employed Contributions Act (SECA). In 2024, the total Social Security tax rate is 12.4%. Employees and their employers each cover half, contributing 6.2% of the employee's wages. Self-employed individuals pay the entire 12.4%, but it only applies to 92.35% of their net earnings.

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The Income Limit for Social Security Taxes

Not all income is subject to Social Security taxes. There’s a cap, also known as the wage base limit. In 2024, this cap is set at $168,600, meaning you won’t owe Social Security tax on any earnings beyond that amount. The cap changes annually to adjust for inflation, so it’s important to stay informed.

For example, let’s say you earn $200,000 in 2024. You will only pay Social Security taxes on the first $168,600, and the remaining $31,400 will not be taxed for Social Security purposes. This cap can create a regressive tax structure where higher earners pay a lower effective Social Security tax rate compared to lower earners.

Social Security Taxes for the Self-Employed

For self-employed individuals, Social Security taxes work a little differently. Instead of splitting the tax with an employer, self-employed workers are responsible for the full 12.4% tax. In addition, they must also pay the Medicare tax, making the total self-employment tax 15.3%. However, this only applies to 92.35% of their net business income.

Consider this example: Mike, a self-employed consultant, has a net income of $200,000. He pays Social Security tax on 92.35% of that, or $184,700. Since this exceeds the income limit of $168,600 for 2024, his Social Security tax liability will be 12.4% of $168,600, which amounts to $20,902.80. Mike can also claim an above-the-line deduction for half of his self-employment tax, which reduces his taxable income.

Exemptions from the Social Security Tax

Not everyone is required to pay Social Security taxes. Certain groups may qualify for exemptions, including:

Nonresident aliens (e.g., temporary students or individuals working for foreign governments)
Members of religious groups with specific beliefs against Social Security benefits
Students employed at the educational institution where they are enrolled

These exemptions are relatively rare, but if you fall into one of these categories, it’s worth looking into your tax obligations.

Are Your Social Security Benefits Taxable?

Once you start receiving Social Security benefits, the amount of Social Security benefits subject to taxes varies depending on your total income. The IRS uses a formula to determine whether your benefits are taxable. Here’s how it works:

Add half of your Social Security benefits to all other income sources, such as wages, withdrawals from retirement accounts, and investment income.
If the total is more than $25,000 for single filers or $32,000 for married couples filing jointly, a portion of your benefits will be taxable.

Let’s break it down by income levels:

Lower Income: If your total income is between $25,000 and $34,000 for single filers (or $32,000 to $44,000 for married couples), up to 50% of your Social Security benefits are taxable.
Higher Income: If your income exceeds $34,000 for singles or $44,000 for couples, up to 85% of your benefits may be subject to taxes.

However, no matter what your income, at least 15% of your Social Security benefits will always be excluded from your federal taxable income.

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State Taxes on Social Security Benefits

While the federal government may tax your Social Security benefits, not all states follow suit. Only 9 states impose taxes on Social Security benefits in 2024. These states are:

Colorado
Connecticut
Minnesota
Montana
New Mexico
Rhode Island
Utah
Vermont
West Virginia (which will eliminate their tax in 2026)

Each state has different rules regarding the taxation of benefits, so if you live in one of these states, be sure to review the specific guidelines.

On the other hand, many states do not tax Social Security benefits at all. If you live in states like Florida, Texas, or California, your Social Security income is safe from state taxes.

Working Before Full Retirement Age

Another factor to consider is whether you plan to continue working while receiving Social Security benefits. If you start receiving benefits before reaching full retirement age (currently 67 for those born after 1960), your benefits could be reduced if you have earned income above a certain limit.

For example, in 2024, if you earn more than $22,320 while receiving Social Security before your full retirement age, $1 will be deducted from your benefits for every $2 you earn over the limit. In the year you reach full retirement age, the limit is higher—$59,520—and the deduction is less severe, with $1 being deducted for every $3 you earn above the limit. Once you reach full retirement age, you can earn as much as you want without affecting your Social Security benefits.

How to Reduce Your Social Security Taxes

Proper tax planning can help you reduce the amount of taxes you pay on your Social Security benefits. Here are some strategies to consider:

Keep Income Low in Retirement: By keeping your annual income under certain thresholds, you can reduce the portion of your Social Security benefits that are subject to tax.
Use Tax-Advantaged Accounts: Shifting income-generating assets into tax-advantaged accounts like Roth IRAs can help minimize taxable income during retirement.
Delay Withdrawals: Minimize withdrawals from retirement accounts until you need them. This can help keep your income lower and reduce your overall tax burden.
Donate RMDs to Charity: If you’re required to take minimum distributions from pre-tax retirement accounts, consider donating those distributions to charity if you are older than 70 ½. This can help you avoid taxes on those withdrawals while also supporting causes you care about.

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Bottom Line

Social Security taxes are an essential part of the U.S. tax system, funding benefits for retirees, survivors, and people with disabilities. Whether you’re still working or receiving benefits, it’s important to understand how Social Security taxes affect you and how you can plan to minimize their impact on your retirement income.

By staying informed about tax brackets, income limits, and tax strategies, you can ensure that you’re making the most of your benefits while keeping as much of your hard-earned money as possible. As always, consult with a financial advisor or tax professional to tailor these strategies to your specific situation.

Proper planning today will help you secure a more financially stable retirement tomorrow.

Reference

Social Security Administration. (2022). Annual Statistical Supplement 2022: Social Security (Old-Age Survivors and Disability Insurance) Program Description and Legislative History. Retrieved from the Social Security Administration website: https://www.ssa.gov/policy/docs/statcomps/supplement/2022/index.html

Social Security Administration. (2024). Fact Sheet: 2024 Social Security Changes. Retrieved from the Social Security Administration website: https://www.ssa.gov/news/press/factsheets/colafacts2024.html

Internal Revenue Service. (2023). Topic No. 751 Social Security and Medicare Withholding Rates. Retrieved from the IRS website: https://www.irs.gov/taxtopics/tc751

Internal Revenue Service. (2023). Self-Employment Tax (Social Security and Medicare Taxes). Retrieved from the IRS website: https://www.irs.gov/taxtopics/tc554

Social Security Administration. (2023). Income Taxes and Your Social Security Benefit. Retrieved from the Social Security Administration website: https://www.ssa.gov/benefits/retirement/planner/taxes.html

Social Security Administration. (2023). Social Security Handbook 1128: When May Members of Certain Religious Groups Receive an Exemption From the Social Security Tax? Retrieved from the Social Security Administration website: https://www.ssa.gov/OP_Home/handbook/handbook.html

Internal Revenue Service. (2023). Aliens Employed in the U.S.—Social Security Taxes. Retrieved from the IRS website: https://www.irs.gov/individuals/international-taxpayers/aliens-employed-in-the-united-states-social-security-taxes

Social Security Administration. (2023). Social Security Coverage for Employees of Foreign Governments and Instrumentalities of Foreign Governments Working in the United States. Retrieved from the Social Security Administration website: https://www.ssa.gov/international/Foreign_Governments.html

Internal Revenue Service. (2023). Student Exception to FICA Tax. Retrieved from the IRS website: https://www.irs.gov/taxtopics/tc460

What Is the Social Security Tax? Definition, Exemptions, and Example. https://www.investopedia.com/terms/s/social-security-tax.asp