Social Security is one of the largest social programs in this country, and it's arguably the most important. While it's possible that Medicare may one day provide a greater tangible lifetime benefit than Social Security, the sheer fact that Social Security is keeping an estimated 22.1 million beneficiaries out of poverty each month gives it the nod for now.
Yet in spite of the key role Social Security plays for its beneficiaries, there's a lot about this program that isn't well understood. How do we know this? Just take a gander at the results of any basic knowledge Social Security survey, and you'll have your answer.
Why are Social Security benefits taxed?
Probably one of the most common questions that pops up on social media regarding Social Security is: Why are Social Security benefits taxed in the first place? To be clear, I'm not talking about why workers are paying tax on their earned income into the Social Security program (you'll see this on your pay stub as a "FICA" tax, and it'll include your portion of Medicare tax, too). Rather, I'm talking about why certain beneficiaries will wind up facing federal, or perhaps even state, tax on a portion of their Social Security benefits.
To answer this question, we need to hop into Doc Brown's DeLorean and take a trip back to 1983.
Just a few years earlier, in 1977, President Jimmy Carter had passed the Amendments of 1977, which were designed to gradually increase the payroll tax on earned income and generate additional revenue for the Social Security program. However, Carter's efforts to right the ship didn't do the trick. By the time 1983 rolled around, Social Security was again running on fumes. If new sources of revenue weren't found by the end of the year, what little the program had in its asset reserves would have been exhausted.
As a quick refresher, Social Security can survive without any excess cash. The program generates the bulk of its revenue from the 12.4% payroll tax on earned income of up to $128,400. Last year, more than 87% of the nearly $1 trillion collected came from its payroll tax. However, a persistent net cash outflow where expenditures are higher than revenue creates an unsustainable payout schedule. Had the Reagan administration done nothing in 1983, benefit cuts would have been needed for then-current and future beneficiaries.
The taxation of benefits is introduced
In 1983, Reagan and his administration passed the last major overhaul of the Social Security program with the amendments of 1983. The biggest changes included the gradual increase of the full retirement age from 65 to 67 between 1983 and 2022, and the implementation of the taxation of benefits -- the latter of which went into effect in 1984.
Here's how the taxation of Social Security benefits works. If the adjusted gross income (AGI), plus one-half of benefits, exceeds $25,000 for a single taxpayer, or $32,000 for a couple filing jointly, then up to half of those Social Security benefits become subject to ordinary federal income tax rates. If AGI plus one-half of benefits is below these amounts, then no federal tax is imposed. It's worth noting that 13 states also tax Social Security benefits to some varied degree.
When first implemented, this tax was only expected to affect about one in every 10 senior households. Its purpose was designed to generate extra income for the program. Meanwhile, the gradual increase to the full retirement age is a means to reduce the lifetime benefits paid to future generations of workers. Together, these factors, along with the gradual payroll tax increase passed under Carter, were aimed at putting Social Security on better footing for the long run.
A second tier of taxation is added
Though things looked promising initially, the Board of Trustees in 1985, and for each subsequent year, has issued a warning in its report that the program doesn't have sufficient revenue to sustain the current payout schedule over the long term (i.e., the next 75 years). That's why, in 1993, the Clinton administration introduced a second tier of taxation to Social Security benefits.
In addition to being exposed to taxation if AGI plus one half of benefits exceeds $25,000 for a single taxpayer or $32,000 for a couple filing jointly, the 1993 amendment allowed up to 85% of benefits to be exposed to federal taxation if a single taxpayer crossed $34,000, or a couple earned more than $44,000. Once again, this move was made to generate more income for the program.
The downside, of course, is that none of the income thresholds have been updated since their passage in 1983 and 1993. Whereas only one in 10 senior households was subject to taxation back in 1983, there are an estimated 56% of senior households subject to taxation today, according to The Senior Citizens League.
Why doesn't Congress scrap the taxation of benefits and help middle-income seniors?
Now that you have a better understanding of why this tax was implemented in the first place, you're probably wondering why it's not shelved by Congress. In essence, if beneficiaries no longer had to worry about being taxed on a portion of their Social Security benefits, then 56% of seniors would get a raise of sorts. This would be particularly beneficial to middle-income retirees who might otherwise be struggling to make ends meet.
But here's the reality: Social Security is facing an estimated $13.2 trillion cash shortfall between 2034 and 2092, and the program needs every cent in revenue it's going to get. As net cash outflows in the program commence in 2018 and widen in 2020 and beyond, the interest income collected by Social Security is expected to dwindle. Thus, not only are demographic changes straining Social Security, but one of its three sources of funding could disappear by 2034.
As time passes, the taxation of benefits is expected to take on a more important role in revenue generation. Having brought in $37.9 billion in 2017, the trustees forecast that it'll generate $88.1 billion for the program by 2027, surpassing interest income in annual revenue in 2026. Not only can the federal government ill afford to get rid of the taxation of benefits, it can't even consider adjusting the taxation thresholds for inflation.
And as the icing on the cake, Democrats and Republicans agree on so little when it comes to Social Security that altering how the program is funded in any way appears impossible at the moment.
Sorry to say, folks, but the taxation of benefits is here to stay.