The income you receive from your 401(k) or other qualified retirement plan will not affect the amount of Social Security benefits you receive each month. However, you may be required to pay taxes on some or all of your distributions if your annual income exceeds a certain threshold — and your 401(k) distributions can cause this to happen.
Key learning points
- Social Security retirement benefits do not change based on other retirement income, such as from 401(k) plan funds.
- Instead, Social Security income is calculated based on your lifetime earnings and the age at which you choose to receive Social Security benefits.
- However, distributions from a 401(k) can increase your total annual income to a point where your Social Security income is subject to taxes.
Why does 401(k) income not affect Social Security?
Your Social Security benefits are determined by the amount you earned during your working years – years in which you paid into the system through Social Security taxes. Since contributions to your 401(k) are made with compensation you received from a U.S. company, you have already paid Social Security taxes on those dollars.
But wait — weren’t your contributions to your 401(k) account made with pre-tax dollars? Yes, but this tax shelter feature only applies to federal and state income taxes, not Social Security. You still pay Social Security taxes on the full amount of your compensation, up to a predetermined annual limit set by the IRS, in the year you earned it. This limit is typically increased annually and is currently capped at $142,800 for 2021.
“Contributions to a 401(k) are subject to Social Security and Medicare taxes, but are not subject to income taxes unless you pay a Roth (after-tax) contribution,” notes Mark Hebner, founder and president of Index Fund Advisors Inc. in Irvine, California, and author of Index funds: the 12-step recovery program for active investors.
In a nutshell, this is why you owe income tax on 401(k) distributions when you take them, but not Social Security tax. And the amount of your Social Security benefit is not affected by your 401(k) taxable income.
The Tax Impact of 401(k) Savings
Once you start taking distributions from your 401(k) or other retirement savings plan, such as an IRA, you will not owe Social Security tax on the distribution for the reason described above; you paid your contribution during your working years. But you may have to pay income tax on part of your distributions if your joint annual income exceeds a certain amount.
The income thresholds are based on your “combined income,” which is equal to the sum of your adjusted gross income (AGI), including wages earned, withdrawals from retirement savings accounts (such as IRAs and 401(k)s, any untaxed earned interest and half of your Social Security benefits). If you take large distributions from your traditional 401(k) in any year you receive benefits – and remember that you must start taking them from all 401(k)s once you turn 72 – you are more likely to have more than the income limit and increase your tax liability for the year.
According to the Social Security Administration, for 2020, if your total income for the year is less than $25,000 and you’re filing as an individual, you don’t have to pay pay taxes on a portion of your Social Security benefits. If you are filing together as a married couple, this limit is increased to $32,000.
You may be required to pay taxes on up to 50% of your distributions if you are an individual with income between $25,000 and $34,000, or if you file jointly and have income between $32,000 and $44,000. Up to 85% of your distributions may be taxable if you are single and earn more than $34,000 or if you are married and earn more than $44,000.
Other Factors Affecting Social Security Benefits
In some cases, other types of retirement income can affect your benefits, even if you receive benefits in your spouse’s account. Your benefits may be reduced to take into account the income you receive from a pension based on income from a government job or from another job for which your earnings were not subject to Social Security taxes. This particularly affects people who work in state or local government positions, the federal government, or those who have worked for a foreign company.
If you work in a government position and receive a pension for work that is not subject to Social Security taxes, your Social Security benefits received as a spouse, widow or widower are reduced by two-thirds of the amount of the pension. This rule is called the Government Pension Offensive (GPO).
For example, if you qualify for $1,200 in Social Security but also receive $900 a month from a state pension, your Social Security benefits will be reduced by $600 to account for your retirement income. This means that your Social Security benefit is reduced to $600 and your total monthly income is $1,500.
The Windfall Elimination Provision (WEP) reduces the unfair advantage given to those who receive benefits on their own account and receive a pension based on income for which they have not paid Social Security taxes. In these cases, the WEP simply reduces Social Security benefits by a certain factor, depending on the applicant’s age and date of birth.
What determines your Social Security benefit?
The amount of your Social Security benefit is largely determined by how much you earned during your working years, your age at retirement, and your expected lifespan.
The first factor that affects your benefit amount is the average amount you earned while working. Basically, the more you earn, the higher your benefits will be. The SSA’s annual factsheet shows that employees who retire at full retirement age can receive a maximum benefit amount of $3,148 for 2021 and $3,345 for 2022. The Social Security Administration calculates an average monthly benefit amount based on your average income and the number of years you are expected to live.
In addition to these factors, your retirement age also plays a crucial role in determining your benefit. While you can start receiving Social Security benefits from age 62, your benefit amount will be reduced for each month you start collecting before full retirement age. The full retirement age is 66 and 10 months for those turning 62 in 2021. It will be increased by two months each year until it reaches the current maximum retirement age of 67 for anyone born in 1960 or later.
Conversely, your benefit can be increased if you continue to work and receive a postponement of your benefit after full retirement age. For example, in 2021, the maximum monthly benefit amount for those retiring at full retirement age is $3,148. For those who retire early, at age 62, the maximum drops to $2,324, while those waiting until age 70 — the last thing you can delay — can receive a benefit of $3,895 per month.
To ensure that benefits maintain their purchasing power, the Social Security Administration adjusts them each year to reflect changes in the cost of living. For example, from January 2022, the COLA will cause Social Security and Supplemental Security (SSI) benefits to increase by 5.9%.
It comes down to
Income from a 401(k) will not affect the amount of your Social Security benefits, but it can increase your annual income to a point where they are taxed or taxed at a higher rate. This can be puzzling to someone who is at an age where they need to both start withdrawing from the 401(k) and start collecting Social Security.
Either way, be aware of the annual changes in Social Security income thresholds and consider tax liabilities when planning your retirement or deciding how much a 401(k) benefit should be.