Does Michigan Tax Social Security Benefits?

Recent legislative changes have made Michigan’s taxation of Social Security benefits more favorable for retirees. For years, the state had specific rules for taxing various retirement incomes, but a new law has created different options for taxpayers. While Social Security and other retirement benefits were previously taxed based on a multi-layered system, retirees now have choices that can lower their state tax liability.

Federal Taxation of Social Security Benefits

Before examining Michigan’s specific rules, it is important to understand how the federal government treats Social Security. The taxability of your benefits at the federal level depends on what the IRS calls “combined income.” This figure is calculated by taking your adjusted gross income (AGI), adding any nontaxable interest you’ve earned, and then adding one-half of the Social Security benefits you received for the year.

The portion of your benefits subject to federal income tax depends on your combined income and filing status:

• Single filers with a combined income under $25,000 pay no tax on their benefits.
• Single filers with a combined income between $25,000 and $34,000 may have up to 50% of their benefits taxed.
• Single filers with a combined income over $34,000 may have up to 85% of their benefits taxed.
• Married couples filing jointly with a combined income under $32,000 pay no tax on their benefits.
• Married couples filing jointly with a combined income between $32,000 and $44,000 may have up to 50% of their benefits taxed.
• Married couples filing jointly with a combined income over $44,000 may have up to 85% of their benefits taxed.

Michigan’s Previous Retirement Tax System

Prior to recent changes, Michigan’s approach to taxing retirement and pension income was structured under a three-tiered system based on the taxpayer’s year of birth. For joint filers, the birth year of the older spouse was used to determine which tier applied.

Taxpayers born before 1946 were in “Tier 1.” They were able to deduct all of their Social Security and public pension benefits. They could also deduct private retirement income up to a certain limit.

Those born between 1946 and 1952 fell into “Tier 2.” These taxpayers were eligible for a deduction against all types of income, capped at $20,000 for single filers and $40,000 for joint filers once they reached age 67. Taxpayers born after 1952 were in “Tier 3,” where their retirement and pension income was fully taxable.

The New Michigan Retirement Income Exemption

Public Act 4 of 2023, also known as the Lowering MI Costs Plan, initiated a phase-out of the state’s tax on most retirement and pension income, moving away from the previous birth-year-based system. The changes are being implemented over a four-year period, starting with the 2023 tax year. This will eventually provide a full exemption for this income by 2026, regardless of a retiree’s birth year.

The phase-in is structured as a gradually increasing deduction. For the 2023 tax year, eligible taxpayers could deduct 25% of their retirement income. This percentage increases to 50% for 2024, 75% for 2025, and reaches a 100% deduction for the 2026 tax year and beyond.

Eligibility for these new deductions during the phase-in period is also tied to birth year, with the rules expanding eligibility each year. For tax year 2023, only those born before 1959 could claim the new deduction. By 2026, all retirees will be able to fully deduct their qualifying retirement and pension benefits. The law also provides an immediate full deduction for retirement benefits received by retired public safety officers, such as police and firefighters, starting in 2023.

Choosing Your Best Tax Option

During the four-year phase-in period from 2023 to 2026, Michigan retirees have the flexibility to choose the most financially advantageous tax treatment for their retirement income. Each year, a filer can select either the old, tiered deduction system or the new, percentage-based exemption. This choice is made annually, allowing taxpayers to adapt their strategy as the new exemption becomes more generous each year.

A taxpayer must calculate their deduction under the old rules and compare it to the deduction available under the new phase-in schedule. For instance, a Tier 2 taxpayer would compare their standard $20,000/$40,000 deduction to the percentage-based deduction offered under the new law for that tax year.

This comparison is documented on Michigan’s tax forms, specifically the Michigan Pension Schedule (Form 4884). While the new percentage-based deduction will likely be more beneficial for most retirees as it grows each year, some individuals with specific income profiles might find the old system more favorable in the early years of the phase-in.