For better or worse, Social Security is our country's most important social program. Founded in the mid-1930s and paying out benefits to retired workers since Jan. 1, 1940, it's a program that, today, is leaned on to keep more than 15 million seniors a year out of poverty.
It's also an incredibly expensive program to operate. Last year marked the first time in Social Security's history that aggregate expenditures -- benefits paid plus Railroad Retirement exchange transfers and administrative expenses -- topped $1 trillion. Ensuring that the proverbial gerbil remains on its wheel means collecting a lot of money each and every year.
The payroll tax does Social Security's heavy lifting
Since 1937, payroll taxes on earned income have been the primary source of funding for Social Security. Last year, $885 billion of the just over $1 trillion in income collected by the program was derived from the 12.4% tax on earned income, which includes salary and wages but not investment income. Keep in mind that this tax comes with a cap of $132,900 in earned income in 2019, albeit this upper limit tends to increase in step with the National Average Wage Index each year, as long as there's a positive cost-of-living adjustment.
Social Security's payroll tax is a big reason why the program can never go bankrupt. As long as Congress doesn't change how the program collects money, the fact that Americans continue to work, earn wages, and pay tax on those wages ensures that some amount of income will always be flowing into the Social Security program.
It's worth noting that Social Security also gets a pretty decent amount of revenue each year from the interest it earns on its excess cash. By law, the Social Security Administration is required to invest the program's net-cash surpluses in special-issue bonds, which vary in yield and maturity date. With close to $2.9 trillion currently in reserves at an average yield of more than 2.8%, it's no surprise that Social Security is racking up more than $80 billion in interest income a year on Uncle Sam's tab. Last year, the interest income on the program's asset reserves resulted in the collection of $83.1 billion.
This unpopular revenue source is growing in importance
But there's a third means of revenue collection for the Social Security program that typically flies under the radar. It's certainly not popular among the public, but it's on track to generate nearly $600 billion in revenue for Social Security, in aggregate, over the next decade. Let me introduce you to the taxation of Social Security benefits.
In 1983, when the last major overhaul of the Social Security program was passed under the Reagan administration, one of the many new amendments to the program included a tax on a portion of an individual's or couple's Social Security benefits if they crossed above select income thresholds. Implemented officially in 1984, it allowed the federal government to impose ordinary income tax rates on up to 50% of benefits paid if a person's modified adjusted gross income (MAGI) plus one-half of benefits exceeded $25,000 (or $32,000 for a couple filing jointly). When implemented, it was only expected to affect roughly 1 out of 10 senior households.
But this wasn't the last we'd see of taxing Social Security benefits. In 1993, under the Clinton administration, a second tier of taxation was added that allowed the federal government to tax up to 85% of benefits. Using the same formula noted earlier, an individual or couple whose MAGI plus one-half of benefits exceeds $34,000 or $44,000, respectively, becomes subject to this higher rate of taxation on their Social Security benefits.
Here's a rundown of what the Social Security Board of Trustees expects in revenue from the taxation of benefits over the next decade:
- 2019: $36.9 billion
- 2020: $40.2 billion
- 2021: $44.1 billion
- 2022: $48.1 billion
- 2023: $52.3 billion
- 2024: $56.9 billion
- 2025: $62.1 billion
- 2026: $78.2 billion
- 2027: $85.0 billion
- 2028: $92.3 billion
If you're wondering, the big jump in projected revenue collection after 2025 has to do with the expected sunset of the individual tax cuts on Dec. 31, 2025, that were implemented as part of the Tax Cuts and Jobs Act.
Here's why you'll probably be paying this tax when you retire
As you can see from the Trustees' projections, the amount being collected by the taxation of benefits is expected to more than double, on an annual basis, over the next decade. But this tax leaves a sour taste in the mouths of most Social Security recipients for two reasons.
First of all, a tax on benefits is viewed by many as a form of double taxation. The thesis here is that earned income is subject to the payroll tax, so an additional tax on paid benefits is a form of double taxation.
While I can certainly empathize with this gripe, it's not entirely accurate. For starters, not all Social Security income comes from taxation. As noted, $83.1 billion was collected last year from interest earned on the program's asset reserves.
Furthermore, the tax dollars you pay into the system aren't the benefit dollars you'll be receiving at a later date. Social Security is predominantly a social investment in our nation's retired workforce and not an investment such as a retirement account. That means what you put into the system could be more or less than what you'll receive in lifetime benefits.
However, if you also wind up living in one of the 13 states that taxes Social Security benefits to some varied degree, and you're hit with a state-level tax on your benefits, then that would be a true form of double taxation on your payout.
The second gripe is that the aforementioned income thresholds (MAGI plus one-half of benefits) at the 50% and 85% tax tiers have never been adjusted for inflation. Thus, while only expected to impact around 10% of senior households in 1983, the taxation of benefits affects half of all senior households today. Since this tax is becoming an increasingly important source of revenue for Social Security, it's unlikely that lawmakers will update these thresholds for inflation. Or, to put this into context, more and more seniors are going to be exposed to the taxation of Social Security benefits with each passing year.