The year 2025 is set to bring some changes to Social Security, including a 2.5% cost-of-living adjustment (COLA). While this increase might seem like a win for retirees, it could have unintended tax implications for some. Addressing how Social Security benefits are taxed and how to minimize tax liability is crucial for beneficiaries.
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Combined Income
Contrary to popular belief, Social Security benefits are not taxed directly unless combined with other income sources. Federal taxation on Social Security is based on what is called “combined income.” This is calculated using the following formula:
- Adjusted Gross Income (AGI): Your total taxable income from all sources.
- Nontaxable Interest: For instance, interest from municipal bonds.
- 50% of Your Social Security Benefits: Half of your annual Social Security benefits.
The sum of these three components determines whether your benefits are taxable and, if so, the portion subject to federal taxes. Although most states exempt Social Security from taxation, federal taxes apply if your combined income exceeds certain thresholds.
Taxable Benefits Thresholds
Depending on your combined income, you might owe federal taxes on up to 50% or 85% of your Social Security benefits. Here’s how it works:
| Taxable Percentage | Single Filers | Joint Filers |
|---|---|---|
| Up to 50% | $25,000–$34,000 | $32,000–$44,000 |
| Up to 85% | Over $34,000 | Over $44,000 |
For retirees whose combined income remains below $25,000 (single) or $32,000 (joint), Social Security benefits are not subject to federal taxes.
Taxes on Benefits
Originally, when Social Security benefits became taxable in 1984, only about 10% of recipients were expected to owe taxes. Fast forward to today, and approximately 50% of retirees pay federal taxes on their benefits. The reason? The thresholds for combined income haven’t been adjusted for inflation in decades. As COLA increases and other income sources grow, more beneficiaries are pushed over these outdated thresholds.
The Senior Citizens League, a nonpartisan advocacy group, highlights that these stagnant thresholds are leading to disproportionate taxation on retirees, creating an additional financial burden.
How to Minimize Taxes
Fortunately, retirees can take steps to reduce their taxable benefits:
1. Manage Withdrawals
Reducing the amount withdrawn from traditional IRAs, 401(k)s, or other taxable accounts can help lower your AGI. By limiting withdrawals, you may be able to stay under the tax thresholds.
2. Plan RMDs
While RMDs must be taken starting at age 73 (as of 2023), careful planning can minimize their impact on your combined income. Spreading withdrawals across the year may help manage taxable income.
3. Consider Roth Conversions
Roth IRA withdrawals do not count toward AGI, making them an attractive option for reducing taxable income. Converting some traditional retirement funds to a Roth IRA may provide long-term tax benefits.
4. Time Income Strategically
Deferring income, like selling investments in a year when your other income is lower, can help keep you under the thresholds for taxable benefits.
5. Optimize Investment Income
Investing in assets that generate tax-exempt interest, like municipal bonds, can help lower your combined income.
Key Takeaway
While the 2.5% COLA increase in 2025 is intended to help retirees keep up with inflation, it’s crucial to consider its potential tax implications. Addressing the thresholds for combined income and implementing strategies to minimize taxable income can help retirees avoid unnecessary taxes and make the most of their Social Security benefits.
FAQs
What is combined income?
It is the sum of AGI, nontaxable interest, and half of Social Security benefits.
How much of Social Security benefits can be taxed?
Up to 50% or 85%, depending on combined income thresholds.
What are the taxable thresholds for Social Security?
$25,000 for singles and $32,000 for joint filers for partial taxation.
Why are more retirees taxed on benefits?
Combined income thresholds haven’t been adjusted for inflation since 1984.
How can I lower taxes on Social Security?
Reduce withdrawals, use Roth IRAs, and time your income strategically.
