Social Security benefits have been subject to income tax since 1984. What is overlooked is the illogical fact that the income threshold that triggers taxation of Social Security benefits has not been adjusted since it was put in place.
Nearly 30 years without adjustment means that more and more Social Security income is subject to federal income tax every year. This form of silent tax affects current retirees over the course of a long retirement but the largest injustice is served on younger workers who may not be fully reimbursed for what they pay into the Social Security system via payroll taxes. And yet, most of them have no idea that their own financial security in retirement could be reduced by this taxation.
In the 1983 amendments to the Social Security Act, Congress decided that 50 percent of an individual or couple’s Social Security benefits would be subject to tax if adjusted gross income — including nontaxable municipal bond income and half of Social Security income — exceeded $32,000 for married taxpayers or $25,000 for single taxpayers.
In 1993, an element of means testing was added. For couples with more than $44,000 of income ($34,000 for single taxpayers), 85 percent of Social Security income is subject to federal income tax and, in many states but not in Washington, state income tax.
THE TAX NET GETS WIDER AND WIDER
Consider the effect of the unadjusted threshold. Imagine that you received a $500 monthly Social Security payment in 1984. Applying the actual Social Security cost-of-living adjustments each year since then would result in a 2012 monthly benefit of $1,228.40 — a 125 percent increase in Social Security income. But the income threshold subject to taxation has not changed at all.
When this tax started, it affected 3 percent of retirees. Now, more than 30 percent of Social Security recipients have their benefits taxed. That number will continue to grow unless the income threshold is adjusted. If we fast forward another 30 years without adjusting the income limit, extending the same example above, the 2042 monthly benefit would be $2,645 per month — a 429 percent increase over the 1984 Social Security payment but with no increase in the figure that determines the level of taxation on those benefits.
Considering all the other elements of the tax code that are adjusted for inflation (such as the Alternative Minimum Tax), it’s baffling that there has been no adjustment to Social Security tax thresholds for an entire generation.
People who live off only Social Security income aren’t burdened by the taxation of that income. But if your retirement income includes withdrawals from an IRA or 401k, or you have a pension or rental income, you can easily surpass the threshold that determines taxation of Social Security.
Keeping your income below the 85 percent taxable threshold of $44,000 creates meaningful tax savings. If a couple were to each receive today’s average Social Security payment, the difference in tax due between 50 percent of their Social Security income being taxed and 85 percent of it taxed is $2,461 this year in the 25 percent federal income tax bracket. The difference in amount of tax due will increase each year that the Social Security income adds a cost of living increase.
PERSONAL SAVINGS RESONSIBILITY GROWS
The younger you are, the more inequality you will experience. Social Security is not meant to entirely replace your income from your working years. But for current retirees, the percentage of income that Social Security does replace will generally be much higher than for future retirees.
The takeaway here is that current workers, especially the young, will have to save much more of their disposable income for retirement than current retirees did. Of course, not everyone is in position to maximize their retirement plan contributions to overcome this hurdle.
This means that more people will have to work longer to afford retirement, and by then, the Social Security full retirement age may be stretched higher as well, further reducing the benefits that future recipients will receive from Social Security over their lifetime.
ANOTHER EDGE FOR THE ROTH IRA
Distributions from a Roth IRA are not taxable income. Therefore, withdrawals from a Roth in retirement will not increase taxation of Social Security income.
Current workers can utilize Roth options within an employer retirement plan or fund a Roth IRA if eligible. It also may make sense for many people to convert some of their current pre-tax retirement savings in Traditional IRAs or employer retirement plans to a Roth IRA. This creates a separate taxation issue so, especially for current retirees, it may be wise to convert assets to a Roth in small chunks each year.
Gary Brooks is a certified financial planner at Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma. Reach him at gary@bhjadvisors.com.
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