As of 2012, 28 states and the District of Columbia don't tax your Social Security benefits even when the federal government does. States that do take a cut use a variety of different approaches. If tax rates make a difference in where you retire, find each state's tax or revenue department online and compare the alternatives.
Seven states -- Minnesota, Nebraska, North Dakota, Rhode Island, Utah, Vermont and West Virginia -- tax as much of your Social Security benefits as the federal government does. When Social Security is your only income, it's free from federal tax. If you have other money coming in, add your adjusted gross income and any tax-exempt interest you earn to half your Social Security benefits. If the total is $32,000, as of 2012, and you file a joint return, half your benefits are taxable. If the total exceeds $44,000, 85 percent is taxed. The seven states follow the same policy.
If all states applied the federal formula, that would make things simpler -- but not completely simple. Some states calculate your adjusted gross income differently from the IRS: They exclude different sources of income and include others. The result is that even if your taxable income is large enough to trigger federal income tax on Social Security, it may not do the same at the state level. You also could wind up paying the state but not the feds.
Other states apply their own formulas and rules for taxing Social Security. In Connecticut, for example, if you report less than $60,000 in adjusted gross income on a joint return, you don't pay state income tax on your benefits. The higher your income above that level, the more of your benefits become taxable. Colorado provides a general tax exclusion for retirement income, which can protect Social Security even if your benefits are otherwise taxable.
When you expect to owe federal income tax on your benefits, you can ask the government to withhold taxes on your benefits, at either a 7, 10, 15 or 25 percent rate. The Social Security Administration does not take out anything you need to cover state taxes. One solution is to pay estimated tax to the state every quarter, the same method freelancers use to substitute for withholding. Talk to your state department of revenue about what's required.
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