How to Fix, Not Cut, the Social Security Benefits Tax

Donald Trump is on to something questioning why the federal government taxes Social Security benefits.

Technically, this isn’t even a tax on benefits. We already impose a tax on additional income that Social Security beneficiaries earn while they collect Social Security checks. If Social Security is the only source of income, then individuals don’t pay any tax on it.

As a result of this tax and other penalties, seniors who continue to work often pay the country’s highest tax rates—much higher than the rates young people with the same income pay. That’s unfair and a punishment for those who work while they collect Social Security benefits.

On the other hand, as others have pointed out, completely eliminating the tax would cost the Treasury large revenue losses at a time when deficits are already exorbitant.

However, there is a way to reform some of the worst features of the tax at low cost.

Under current law, if one-half of Social Security payments plus other income exceeds $25,000, the individuals must pay income taxes on 50 cents of Social Security benefits for each additional dollar they earn. Since they also must pay regular income taxes on that dollar, they have to effectively pay taxes on $1.50 for every $1 of earnings.

That means that the tax rate on an additional dollar of earnings is 50 percent higher than it would be for a young person with the very same income.

It gets worse.

Once the combined income threshold reaches $34,000, the tax on Social Security benefits rises to 85 percent for each additional dollar they earn. They must pay taxes on $1.85 for each dollar of earnings—85 percent higher than it would be for a young person with the very same earnings.

For someone in the 15 percent bracket for ordinary income:

• The Social Security benefits tax potentially increases the tax rate on pension income and 401(k) and IRA withdrawals from 15 percent to 27.75 percent.
• It can raise the tax on capital gains and dividend income from zero to 12.75 percent.
• Even tax-exempt income can be taxed at a rate of 12.75 percent.

That’s right: Seniors are required to pay a tax on bonds that are supposed to be tax-free.

For most of the system’s history, there was no tax on Social Security benefits. But in 1983, Congress passed legislation to “save” Social Security, mainly with two large benefit cuts: raising the full retirement age and taxing benefits. The original Social Security benefits tax was structured so that it initially hit only very high-income seniors.

But here’s the catch: The benefits tax was intentionally not inflation-indexed. So, while the tax initially was paid by less than 10 percent of retirees, today it is paid by more than half. Unlike other parts of the tax code, inflation imposes an extra tax on most Social Security beneficiaries.

What makes things worse is that working seniors below the full retirement age can face astronomical marginal tax rates when the benefits tax is combined with another unjust “tax”: the Social Security earnings penalty.

This year, early retirees lose 50 cents of Social Security benefits for each dollar they earn beyond $22,320. That’s a 50 percent tax rate.

When income and payroll taxes are added in, senior workers can face a marginal tax rate that exceeds 80 percent—i.e., for every additional dollar they earn, they take home 20 cents.

Note that these high marginal tax rates only apply to middle-income seniors. Low-income seniors don’t earn enough. For high-income seniors, the marginal tax rates go away when benefits have been completely liquidated by the earnings penalty or when they have been “fully taxed” by the benefits tax.

Given our fiscal situation today, it’s likely to cost too much to fix all of these problems in the near future. However, abolishing the earnings penalty would probably be a revenue gainer for the government as seniors work more hours and they and their employers pay additional income and payroll taxes.

We could also eliminate those very high marginal tax rates by including a portion of the benefits in ordinary (taxable) income instead of the Rube Goldberg arrangement we have today. No longer would seniors be paying rates that are effectively 50 percent or 85 percent higher than what other workers pay.

This would also eliminate the stealth inflation tax imposed on seniors because tax rates on ordinary income (unlike the current Social Security benefit tax) are already inflation-indexed.

Seniors who want to continue to work, invest and contribute to the economy shouldn’t be so heavily penalized for doing so. And the government should never benefit from the inflation it causes at the expense of the elderly and the disabled.