Why an Unpleasant Social Security Surprise Awaits More Than Half of All Seniors
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Social Security, the program responsible for providing a financial safety net for roughly 60 million Americans, most of them seniors, is in need of some assistance. If more new revenue isn't generated, or benefits aren't cut, the program will burn through its cash reserves in less than two decades, which would necessitate a 21% cut in benefits for it to stay solvent. This is a point that few would dispute, and a Social Security "fix" is among the hot-button topics of this year's presidential elections.
Social Security's many woes
The problems with Social Security can aptly be summed up in three points.
First, Americans are living longer than ever before. Improvements in medicine, diagnostics, and health education have increased the average life expectancy by almost nine years over the past five decades, according to recent data from the Centers for Disease Control and Prevention. People living longer than ever means they'll be drawing Social Security benefit checks for longer.
Secondly, the baby boomers are entering retirement at a pace of roughly 10,000 people per day. There simply aren't enough new workers coming into the labor force to replace the number leaving it, causing the worker-to-beneficiary ratio to fall. As that ratio continues to decline, the amount of revenue coming in via payroll taxes will grow smaller compared to the amount being paid out to beneficiaries.
Image source: Flickr user David Goehring.
Finally, Americans just really don't have a good comprehension of how Social Security works. MassMutual Financial Group gave a 10-question Social Security quiz to 1,513 people, and only 28% received a passing grade (seven or more correct answers), while just one person answered all 10 questions correctly. If people don't understand the program, then its less likely they're making financially sound decisions about things such as to when to file for benefits.
A Social Security surprise awaiting most seniors
But there may be even more to worry about according to a recent report from The Senior Citizens League, or TSCL.
Based on TSCL's estimations, a whopping 56% of Social Security households could owe some degree of federal income taxes on their Social Security benefits for the 2015 tax season. That's a problem because seniors don't often take into account the potential tax implications of crossing an exemption threshold after they retire.
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As TSCL notes in its report, the income thresholds for taxing Social Security haven't been adjusted since (drum roll please...) 1983. What was once described as a tax that would affect only the top income-earners (or roughly 10% of Social Security recipients) is now on pace to affect well over half of the households receiving Social Security in 2015.
Per the Social Security Administration and IRS, individual income below $25,000 is exempt from taxation. For individuals earning $25,000 to $34,000 per year, up to 50% of Social Security benefits may be taxed. For individuals with incomes above $34,000, up to 85% of their Social Security benefits are taxable.
The ranges are progressive for couples as well. Income below $32,000 for joint-filers is exempt, whereas income between $32,000 and $44,000 may require a tax on up to 50% of Social Security benefits. Income above $44,000 for joint-filers results in a tax of up to 85% of Social Security benefits.
If these exemption figures had kept up with inflation, TSCL notes that the individual exemption threshold in 2015 dollars would be $57,107, and $73,097 for joint-filing couples.
Two things seniors can do to minimize the impact of Social Security taxation
But, there's good news as well. There are two actions seniors and pre-retirees can take to reduce the amount of taxes they'll pay on their Social Security income in retirement.
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First, where you retire to can make a big difference. Aside from federal government, 13 states also tax Social Security benefits, albeit to differing degrees. For example, even though Missouri does tax Social Security benefits, it gives individuals an exemption up to $85,000 in adjusted gross income, annually. Couples are allowed to earn up to $100,000 annually without paying any tax. On the flip side, West Virginia, Minnesota, North Dakota, and Vermont offer no exemption to retirees. Instead, these states choose to follow the federal governments' tax schedule for Social Security from 1983.
In other words, if you choose a state that exempts taxes on Social Security, or at least choose one with high exemption limits such as Missouri, you can at least avoid a state-level tax on your benefit check come retirement.
Second, and most important, ensure that you have a withdrawal plan in place prior to your retirement. Taking the time to iron out how you'll draw down on your nest egg over time not only gives you a better shot of having your money last your entire lifetime, but it'll likely reduce what you'll owe in taxes in a given year.
A smart idea might be to consider opening or adding to a Roth IRA. The Roth has a couple of particularly attractive advantages for seniors that a Traditional IRA or 401(k), which require you to pay taxes upon withdrawal, don't have.
For instance, a Roth IRA allows your money to grow completely free of taxation. Furthermore, contributions to a Roth IRA can be made regardless of age, and there's no required distribution amount, meaning if you want to allow your money to continue to grow while you're in your 70s or 80s, you can choose to do so.
There are, of course, a few limitations to a Roth IRA that you'll want to be aware of. For example, seniors and pre-retirees must meet certain income requirements in order to contribute to a Roth IRA (which can be found on the IRS' website ), and any money contributed can't be withdrawn prior to age 59-1/2, unless there's a qualified reason. Money contributed also cannot be withdrawn for a minimum of five years.
Ultimately, paying taxes on your Social Security benefits certainly isn't optimal, but it doesn't have to be as much of a cost if you do some planning well ahead of time.
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The article Why an Unpleasant Social Security Surprise Awaits More Than Half of All Seniors originally appeared on Fool.com.
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