The income threshold that triggers federal income taxes on your Social Security benefits has not changed since 1984. But the national average wage index used by the Social Security Administration (SSA) to compute benefits has tripled since 1984, and the consumer price index has risen nearly two-and-a-half times.
As a result, more and more individuals and families are paying taxes on their Social Security benefits every year, not because their real incomes have risen significantly but mainly because of rising wage and price levels. The government’s use of a fixed income threshold not adjusted for either inflation or rising wages amounts to both an ongoing tax increase and a means test on Social Security beneficiaries, since taxing benefits based on your income effectively reduces them.
Social Security Benefits Not Always Taxed
On January 31, 1940, Ida May Fuller, a legal secretary from Ludlow, Vermont, became the first person in the United States to receive an old-age monthly benefit check under the then-new Social Security law, enacted in 1935. She was 65 years old. The check was for $22.54. Her total contribution to Social Security, made between 1937 and 1939 during her years of participation in the program, was $24.75. Ida lived to be 100, and collected a total of $22,888.92 in Social Security benefits. Ida never paid a dime of income taxes on her benefits.
For 44 years, Social Security benefits were exempt from federal income tax. Starting in 1984, however, beneficiaries whose income exceeded certain thresholds were taxed on up to 50% of their Social Security benefits. In 1993, the law was further amended to tax up to 85% of Social Security benefits after slightly higher income thresholds are reached.
How to Determine If Your Social Security Benefits Will Be Taxed
How much, if any, of your Social Security benefits are taxable depends on whether your total income exceeds the “base amount” for your income tax filing status. For this purpose, the IRS broadly defines your total income as one-half of your Social Security benefits plus “[a]ll your other income, including tax-exempt interest.” (For related reading, see: Social Security Benefits and Taxes: The Lowdown.)
Total income also includes exclusions and adjustments you’re permitted to take in arriving at your adjusted gross income (AGI). These include interest from qualified U.S. savings bonds, foreign earned income and housing, and the deduction for student loan interest. For a married couple filing a joint income tax return, up to 50% of their Social Security benefits are taxable if their total income exceeds $32,000. If their total income exceeds $44,000, up to 85% of benefits may be taxed. For single people and most other taxpayers, the thresholds are $25,000 and $34,000, respectively.
How the Tax Increase and Means Test Happen
Under our progressive income tax system, tax rates increase as your taxable income increases. To keep people from automatically being pushed into higher tax brackets simply because of inflation, indexing of the income tax brackets for inflation was enacted under President Reagan in 1981 and took effect in 1985. When Congress made Social Security benefits taxable in 1984, however, the income threshold of $32,000 for married couples ($25,000 for most others) was not indexed to inflation in either wages or prices.
In 1984, when the law went into effect, less than 10% of families had to pay income tax on their Social Security benefits. In 2015, 31 years later, a Social Security Administration Issue Paper projected 52% of Social Security beneficiaries would pay income tax on their benefits that year. Among those 52%, the median share of benefits owed as tax was estimated at 11%. In other words, those Social Security beneficiaries who paid taxes on their benefits had their benefits effectively reduced, half of them by more than 11%. A reduction in benefits based on your income, no matter what it’s called, is a means test.
To put this in perspective, if we adjusted the 1984 income threshold at which benefits become taxable to reflect average wage growth, using the SSA’s average wage index table (which SSA uses to make past earnings comparable with current earnings), the $32,000 threshold for married taxpayers today would triple to more than $96,000. The $25,000 threshold for single taxpayers and most others would exceed $75,000 before benefits were taxed. Because the income thresholds that trigger taxation of Social Security benefits are fixed, a family today making about the same inflation-adjusted income as a 1984 family pays tax on up to 85% of their Social Security benefits. The 1984 family paid no tax on their benefits. That amounts to a whopping tax increase.
A Marginal Tax Rate Example
If your total income is near the thresholds at which either 50% or 85% of Social Security benefits become taxable, one dollar of additional income can trigger a significant jump in your marginal tax rate.
For example: Nick and Nora are in the 12% federal income tax bracket. Every dollar of extra income they earn costs them 12 cents in taxes. But if that same extra dollar of income also causes 50% of a Social Security benefit dollar to become taxable, Nick and Nora must now pay tax at 12% on that 50 cents of taxable Social Security benefits, or 6 cents more (50 cents x 12%). Thus, one extra dollar of income now costs 18 cents in taxes (12 cents + 6 cents), and Nick and Nora’s marginal tax rate has now increased from 12% to 18%, a 50% increase!
Tax Planning Opportunities Limited, But Still Available
Unfortunately, because the IRS' definition of total income is so broad, opportunities for avoiding or reducing the tax on your benefits are limited. Most often, your only recourse is to pursue traditional tax-planning strategies to postpone income while accelerating or maximizing certain deductions taken in arriving at AGI (so-called above-the-line deductions).
Deferring the receipt of income — If you have the ability to postpone the receipt of income until the following year, you may be able to reduce both your overall taxes and the taxable amount of your Social Security benefits this year. Examples of items that might be deferrable into next year include taxable IRA or 401(k) distributions (other than required minimum distributions), business income or year-end bonuses.
Harvesting capital losses — Capital losses exceeding capital gains can offset up to $3,000 of ordinary income. Thus, harvesting capital losses could potentially make less of your benefits taxable by reducing your total income. (For related reading, see: How Tax-Loss Harvesting Can Save You Money.)
Maximizing allowable deductions and adjustments to income — Some above-the-line deductions are still allowed when arriving at your total income for benefits taxation purposes. These include IRA and health savings account (HSA) contributions, educator expenses and various deductions available to self-employed people, such as the deductible part of self-employment taxes and the deductions for health insurance and retirement plans.
A combination of these planning techniques could be highly beneficial not only in reducing your overall taxes but also in avoiding the punitive jump in marginal tax rates that results when additional Social Security benefits become taxable.
Putting It All in Perspective
Congress’s goal in making Social Security benefits taxable was to make their tax treatment comparable to that of private pension income, which is generally taxable to the extent that payments exceed worker contributions. The Social Security Administration has estimated the average worker directly contributed in taxes only about 15% of the benefits he or she receives. That is why only up to 85% (100 – 15) of benefits are taxable. This avoids double taxation on the portion of benefit income representing previous contributions. Whether that calculation remains the same for the future, as changes to Social Security are contemplated, remains to be seen.
Later retirement ages, higher limits (or no limits) on the earnings to which Social Security taxes apply, increased FICA tax rates, or lower benefits may argue for reducing the portion of taxable benefits. It’s also important to remember, for individuals and families with total income below the thresholds, all Social Security benefits continue to be tax-free at the federal level. Moreover, 37 states do not currently tax Social Security benefits. The income taxes you pay on your Social Security benefits are credited to the Social Security and Medicare trust funds, which in turn helps continue to fund those programs. Finally, the next time you hear someone saying Social Security benefits should be means-tested, realize that, to a certain degree, they already are.
(For more from this author, see: The Case for Collecting Social Security Early.)