One topic that has continually come up this year is inflation. Even though the Federal Reserve has been aggressively raising interest rates, so far, doing so has not produced much of an impact on this painfully persistent rise in prices. Inflation has been challenging for working individuals, but it has been especially burdensome for many retirees who live off a fixed income.
One of the primary sources of income for many retirees is Social Security. A major benefit of Social Security compared to many other pensions is that it comes with a built-in yearly cost-of-living adjustment. This is one of the main reasons why we are generally proponents of delaying Social Security as long as possible—to the maximum of age 70. This is because the increased benefit for delaying is included in the inflation adjustment when it is calculated.
With inflation being as high as it has been through 2022, the increase of Social Security benefits was expected to be quite substantial. The benefit increase for 2022 was the largest in over a decade, at 5.9%. However, the increase in 2023 will be even larger, with a benefit increase of 8.7%, which is the highest annual increase since the ’80s!
This increase in benefits should provide some relief to many seniors who have been living off a fixed income while prices continue to skyrocket. But the increase in benefits may also come with a change to your tax situation. In this post, we will review some of the possible implications of such a large benefit increase.
Quite a few retirees are surprised to discover that, in many cases, the income they receive from Social Security is taxable. However, not all Social Security income is taxable, depending on your total income. If you file a joint return and your modified adjusted gross income (MAGI) is below $32,000 ($25,00 if single), none of your Social Security is subject to tax. Fifty percent is subject to tax if your MAGI is between $32,000 and $44,000 ($25,000 and $34,000 if single), and 85% is taxable if your MAGI is above $44,000 ($34,000 if single). If 85% of your Social Security income is taxable, that does not mean it is taxed at 85%. What it means is that of the total amount of Social Security income received, 85% of it may be subject to federal income taxes. However, the actual tax rate will be based on the income tax bracket that you are in.
Example: Mary and Mike have a modified adjusted gross income of $50,000 and are in the 22% tax bracket. Of their total income, $10,000 comes from Social Security. This means 85% of their Social Security is taxable, or $8,500 ($10,000 x 0.85). Since they are in the 22% tax bracket, they will pay $1,870 of tax on their Social Security income ($8,500 x 22%).
What may be even more surprising is that not everything in the tax code is tied to inflation. While Social Security benefits increase for inflation each year, the thresholds for what percentage of benefits may be taxable does not. In fact, these thresholds have not increased since Social Security benefits became taxable all the way back in 1983! With such a large benefit increase and the thresholds for Social Security taxability not increasing, this means more retirees will owe tax on their Social Security benefits – if they are not in the 85% taxable threshold already.
Although the thresholds for when Social Security becomes taxable do not increase, the income bands for tax brackets do. Whether the inflation increase of your specific tax bracket is enough when incorporating the additional income from Social Security will vary from person to person. But some retirees may find more of their Social Security income subject to tax in 2023 and may end up in a higher tax bracket as well because of it.
Unlike federal taxes, which are uniform across the nation, each state imposes its own form of state taxes. Depending on where you live, the increase of Social Security benefits may or may not have an impact on how much you pay in state taxes.
As we are based out of New Hampshire, many of our clients live in New Hampshire and Massachusetts. Thankfully for those living in both states, the increase of Social Security benefits will not have an impact on state taxes paid.
New Hampshire does not have an income tax, so any increase to Social Security benefits, regardless of the amount, will not have an impact on retiree income taxes. Although Massachusetts does have an income tax, Social Security income is explicitly excluded from taxable income in the state. So even though there is quite a substantial increase of benefits, it will not impact the tax situation of New Hampshire or Massachusetts state tax returns.
While New Hampshire and Massachusetts taxpayers will not feel a difference in their state taxes, if you live in another state, the increase in Social Security benefits may increase the amount of state taxes you pay. Although taxes are not the only consideration when it comes to where to live in retirement (and maybe they should not be a consideration at all), some states are certainly more tax friendly to retirees than others.
Although inflation has been eating away at fixed incomes all year, retirees on Social Security can expect somewhat of a reprieve when benefit amounts are adjusted starting in 2023. The 8.7% increase in benefits is the largest increase in Social Security in decades. However, with larger benefits may come a higher tax bill, depending on your situation and the state you live in.
If you need help reviewing your tax situation or retirement plan, please reach out to our team.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisor.