Ending the Tax on US Social Security Income Should Be Part of a Broader Reform – Reuters

By Mark Miller

It’s a common and unwelcome surprise for many who reach retirement: Social Security benefits are subject to federal taxes, and in some cases, state taxes as well.

Recently, Republican presidential candidate Donald Trump has floated the idea of eliminating this tax as an incentive to attract voters. The notion of reducing or completely removing taxes on benefits has garnered bipartisan support in Congress, with Democrats also suggesting variations of the idea. However, unlike Trump, many of these proposals include methods to fund the resulting tax cuts, which could potentially cost Social Security and Medicare about $1.5 trillion in revenue over the next decade.

Social Security is already grappling with a solvency issue. According to estimates from the trustees managing the program, the combined retirement and disability trust fund reserves are projected to be depleted by 2035. At that juncture, the program would only generate enough revenue to cover 83% of the benefits promised to current and future beneficiaries, effectively amounting to a 17% cut across the board.

The revenue generated by taxing benefits plays a critical role in funding Social Security and Medicare Part A (hospitalization), and abolishing this tax without a financial offset could shorten the lifespan of Social Security’s funds by as much as two years and the Medicare Part A trust fund by up to six years, according to analysis by the Tax Foundation.

Addressing the depletion of the trust fund is essential for any reform of Social Security. A report from the Urban Institute indicates that allowing the trust fund to run out could increase poverty rates among beneficiaries by over 50%, disproportionately affecting people of color. Conversely, removing the tax on benefits would primarily benefit middle- and higher-income seniors, as the taxation is structured.

Understanding the Tax

Social Security benefits were first taxed in 1984 as part of a broader reform package aimed at stabilizing the program’s finances, which included gradually raising the full retirement age from 65 to 67. While taxes on benefits were not the main focus of the reform, they do contribute to the Social Security and Medicare trust funds. Currently, taxes on benefits account for about 4% of the Social Security trust fund’s revenue.

This tax is calculated using a complex formula that originally only affected higher-income beneficiaries but has been designed to gradually include more individuals over time. While Social Security benefits adjust with wage growth and inflation, the income thresholds determining the taxable amount remain unchanged.

To illustrate, the tax begins with what is termed combined income (or provisional income), which is your modified adjusted gross income (MAGI) plus any nonexempt interest plus 50% of your Social Security benefits. For most individuals, MAGI consists of all items in adjusted gross income apart from the taxable portion of Social Security benefits.

No tax is applied to beneficiaries with a combined income at or below $25,000 for single filers and $32,000 for married couples filing jointly. Those in the next income tier—between $25,000 and $34,000 for singles and between $32,000 and $44,000 for married couples—can be taxed on up to 50% of their benefits. Beneficiaries exceeding those limits may face taxes on up to 85% of their benefits.

Taxing Social Security benefits aligns with the treatment of other retirement income types, such as pensions and 401(k) accounts, where taxes are deferred until the income is received. However, many retirees find this approach contentious, as individuals classified as “higher income” for tax purposes may not necessarily be wealthy by broader societal standards.

Adding to the confusion, states vary widely in their taxation of retirement income, with many exempting or limiting taxes on pensions. Only eight states currently tax Social Security income. Notably, Minnesota’s governor recently enacted legislation exempting most retirees from this tax.

At the federal level, any potential repeal or limitation of Social Security taxation should be paired with a comprehensive reform package that not only restores solvency but also expands benefits. For instance, the Social Security 2100 legislation suggests an across-the-board 2% benefit increase, improved cost-of-living adjustments, and targeted increases for lower-income seniors. According to program actuaries, this bill would allow Social Security to continue paying full benefits for an additional 32 years and propose financing through adjusted payroll taxes for higher earners and a new tax on investment income for wealthy individuals.

Furthermore, this legislation offers exemptions for more beneficiaries from taxes on their benefits by establishing single thresholds ($35,000 for single filers and $50,000 for joint filers) for taxing up to 85% of benefits through 2034, after which the thresholds would revert to current levels.

Conclusion

If there’s a push to lower taxes for higher-income seniors, it should coincide with broader reforms that assist all beneficiaries.