Retirement Matters
September 2024
Discussion of Social Security (SS) Taxation continues from the August 2024 SERA-Nade.
Current Proposals Impacting SS Benefits — As seniors count on SS benefits to make ends meet, those opposing the program are calling for numerous reduction plans like privatizing benefits, reducing the annual cost of living adjustment, sunsetting benefits, and increasing the age of retirement. Others are proposing eliminating the income tax on SS benefits. This would end a portion of the SS trust fund funding that comes from the income tax on SS benefits paid to higher-income beneficiaries, from a 1993 law change. To better understand these proposals, we will review how SS is currently financed and existing taxation of SS benefits.
Payroll Tax — SS is a pay-as-you-go program, where current benefits are financed primarily by the payroll taxes collected from current workers. Presently, both employees and employers are paying a tax rate of 6.2 percent until reaching the wage-based cap of $168,600. Interest earned on SS trust fund bonds also fund SS benefits.
Dedicated Income — Fortunately for retirees, the founders of the SS program structured it with its own dedicated income stream, from the payroll tax, making it harder to reduce or privatize. That way, the payroll tax collections can’t easily be traded off to help finance other important programs like education and defense. Even so, the projected funding for the SS program remains at risk because the projected revenue is only enough to pay full benefits until 2035. After which, Trustees estimate that it could cover about 83 percent scheduled SS benefits.
How Are (SS) Benefits Taxed? — The federal income tax base includes some portion of SS benefits. In addition, Michigan does not tax SS benefits, although ten other states do. If you are less familiar with the rules for paying income tax on SS benefits, realize that you are not alone. The SS tax structure is complex, making it difficult to understand. That said, it’s important to focus primarily on the big picture. Here are some generalized highlights of how the tax works.
- For the purpose of taxing SS benefits, the federal income tax counts income as the money you get from work, pensions, investments, and nontaxable interest. Note that tax exempt interest is included in this income base. Many high-income filers would receive favorable treatment without this inclusion.
- Individual filers pay federal income tax on up to 50 percent of their SS benefits when their annual income is $25,000 to $34,000. The taxable portion of income is the lesser of two calculations.
- Couples filing jointly pay federal income tax on up to 50 percent of their benefits when their annual income is from $32,000 to $44,000. The taxable portion of income is the lesser of two calculations.
- Taxpayers below these income thresholds don’t pay the tax.
- Taxpayers with incomes above these income thresholds, pay federal income tax on up to 85 percent of benefits.
- No one pays income taxes on over 85 percent on their SS benefits, regardless of income. See “Table 1” chart for important details.
SS Income Thresholds — The income thresholds, for those with incomes over the $34,000 (single) or $44,000 (couple), have not been indexed for inflation since they were first established in 1983 and last updated in 1993, are called “bracket creep.” The result is more seniors will be paying income taxes because SS benefits increase due to inflation. The failure of the U.S. Congress to adjust these income thresholds for inflation is eroding the value of SS benefits.
High Wage Earners Pay Higher Percent of SS Benefits — The federal income tax is a progressive tax that is based on the taxpayer’s ability to pay. That means the tax is structured so that high income groups pay a larger percent of their income in taxes, compared to lower income groups. Taxing SS makes the federal income tax more progressive. The “High-Income Taxpayers Pay More Taxes on Social Security Benefits” chart shows that those with incomes of $100,000 and more, owe about 21 percent in income taxes as a share of their SS benefits, according to the Congressional Budget Office (CBO). In contrast, those with incomes of less than $40,000 are paying 0.5 percent in incomes taxes as a portion of their SS benefits. The chart shows that high-income taxpayers, with incomes exceeding $100,000 annually, will benefit the most from eliminating the tax on SS benefits.
Impact on State Employees — Many State employee retirees do not have enough income to be included in a higher-income category. The average State employee retiree receives an average annual pension of $24,598 for 2022. Their SS benefits are based on more modest wages earned decades ago. The point is – you’re not benefiting from eliminating the tax, if you’re not paying much. However, you will lose out on the revenue it captures from the income tax on SS benefits from high-wage earners, paying for everyone’s SS benefits. The highest dollar amount of savings will be realized by the top 0.1 percent. According to the Urban and Brookings institutes, Tax Policy Center, those making $32,000 or less would take a significant financial hit once SS becomes insolvent. Garrett Watson, of the Tax Foundation, says that ending the income tax on SS benefits would reduce tax collections by about $1.4 trillion from 2025 to 2034. Watson suggests indexing the threshold for inflation, along with replacement revenue, instead of eliminating the tax.
Don’t Throw the Baby Out With the Bath Water? — Of course, a retiree’s first reaction to ending income tax on SS benefits could be favorable. But they still expect to receive their full SS benefits. Most policymakers, calling for eliminating the tax, have failed to mention they are not recommending a replacement revenue. However, this substitute revenue is critical, to avoid an even faster erosion of the SS funding, than is already projected. In January, a bill called “You Earned it, You Keep it Act,” proposed eliminating the tax on SS benefits. This bill supported SS benefits, by proposing a revenue replacement, that raises the wage cap on the SS payroll tax.
Editor’s note: Joanne Bump serves as feature columnist for “Retirement Matters.” Column content is time sensitive and is based on information as of 9/8/24. Joanne can be contacted by e-mail at joannebump@gmail.com.
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