Here’s how the ‘Stealth Tax’ on Social Security works. Everything you need to know so you don’t lose money

In the 1980s, as union power was diminished and jobs were sent overseas, pensions began to be replaced by private retirement accounts like 401(k)s and Roth IRAs. Employers can reduce their tax burden as the funds paid into these accounts are deductible. As workers offered these retirement benefits begin to retire, their monthly payments, plus their Social Security benefits, may mean their income continues to be subject to taxation. According to the Social Security Administration (SSA), about forty percent of Social Security beneficiaries pay taxes on their benefits. The income levels were set in 1984 and have yet to be adjusted for inflation, meaning that many more beneficiaries are subject to tax because of these outdated thresholds. Below, you will find the income thresholds determining which Social Security recipients see their benefits taxed and what they would look like if they had been adjusted for inflation.

Some financial planners, like Jordan Gilberti, who serves as a senior lead planner and certified financial planner at Facet, see the fact that these thresholds have not been adjusted as a “stealth tax” as so few understand the mechanisms. In an interview with USA Today, Gilberti said that while many people realize that “Social Security gets taxed,” they often don’t know how, and when he explains the process, “people’s jaws would fall to the ground.” The US Census Bureau put the median household income for seniors at $50,290 in 2022. In other words, many of these households might not be paying taxes on their benefits if these thresholds were adjusted.

How do taxes impact retirement benefits?

Based on the rules above, imagine that a person receives a $1,920.48 check from Social Security (the average for retired workers in August 2024) and $2,000 from their Roth IRA (which the retiree paid taxes on when the funds entered the account). This would provide a retiree of $3,920.48 a month for an annual income of $47,045.76. Since this amount corresponds to up to 85 percent of their benefits being taxed, the question becomes at what rate. Based on the 2023 tax brackets, a retiree would pay a 22 percent tax on at most $16,320 of their annual benefits, equal to $5,070. All in all, the retirees’ tax bill brings their annual estimated income to $41,975.60. If you have a 401(k), as opposed to a Roth IRA, you will also pay taxes when you withdraw funds from your account.

A particularly hard hit for retirees occurs when their income pushes them into a higher tax bracket. In 2023, incomes above $44,726 and $95,375 were taxed at 22 percent, while those falling between $11,001 and $44,725 were taxed at only twelve percent. In the example above, the retirees’ income was not that far off from the upper boundary of the 12 percent bracket, and adjusting their withdrawal from their Roth IRA could help them reduce their tax bill and hold onto a greater share of their savings and benefits. However, with the limits being so low, those couple thousand dollars could be the difference between being able to retire with dignity and struggling to make it to the end of the month.