For more than 80 years, Social Security has played a critical role in providing a financial foundation for retired workers. Today, 62% of retired workers lean on Social Security for at least half of their monthly income, with an analysis from the Centers for Budget and Policy Priorities finding that the program is responsible for pulling more than 15 million seniors out of poverty each year.
But providing for 64-million-plus beneficiaries (retirees, survivors, and the disabled) each year is expensive. Last year, the Social Security program spent almost $1.06 trillion. This means the program needs steady sources of funding to ensure its longevity.
Social Security collects more than $1 trillion in revenue each year
The vast majority of revenue collected by the Social Security program comes from its 12.4% payroll tax on earned income (i.e., wages and taxes, but not investing income) ranging between $0.01 and $137,700, as of 2020. If you're employed by a company or someone else, they cover half of your payroll tax liability; the self-employed are responsible for the full 12.4%.
In 2019, the payroll tax on earned income accounted for $944.5 billion, or 89%, of the $1.062 trillion collected by Social Security. As long as Americans are working, the payroll tax will collect funds that can be disbursed to eligible beneficiaries. You could rightly say the payroll tax ensures that Social Security can never go bankrupt.
Social Security also generates a fair amount of interest income from its asset reserves. These asset reserves are the program's net cash surpluses built up since inception that are legally required to be invested in special-issue government bonds and certificates of indebtedness. With nearly $2.9 trillion in asset reserves, Social Security is able to generate around $80 billion in interest income each year.
Taxing Social Security beneficiaries is quite lucrative
But there's a third source of revenue for Social Security that's absolutely despised by beneficiaries, yet is expected to play an increasingly important role as time moves forward: the taxation of benefits.
Back in 1983, lawmakers were faced with a dilemma. Social Security was slated to burn through its asset reserves in less than 12 months unless lawmakers could pass legislation that would add new revenue and/or reduce long-term expenditures. The result was the Amendments of 1983, which represents the last major overhaul of the Social Security program.
Among the many changes to the Social Security program that were introduced was the taxation of benefits. This new rule allowed the federal government to tax up to one-half of a person's benefits if their modified adjusted gross income (MAGI) plus one-half of benefits topped $25,000 (or $32,000 for a couple filing jointly). In 1993, a second tier of taxation was added that exposed up to 85% of a person's or couple's benefits to federal taxation if their MAGI plus one-half of benefits exceeds $34,000 and $44,000, respectively.
In 2019, the taxation of benefits "only" brought in $36.5 billion, which accounts for 3.44% of total collected revenue. But over the course of the next decade, the taxation of benefits is expected to bring in close to $651 billion, in aggregate, and account for 6.13% of total revenue by 2029. As the program's asset reserves begin to dwindle, along with its interest income, the taxation of benefits is expected to become Social Security's second-leading source of revenue.
You might hate the taxation of benefits, but it's not going away
Despite being a critical cog to the future success of Social Security, there's no sugarcoating seniors' disgust in paying tax on received benefits. One reason for that is that it's viewed as a form of double taxation. Even though it's technically not double taxation -- some of the funds retired workers receive derive from interest income earned on Social Security's asset reserves -- most folks have difficulty viewing it any other way.
The other significant problem with the taxation of benefits is the income thresholds that trigger federal taxation have never been updated to reflect inflation. When the taxation of benefits was introduced in 1984, it only affected about one in 10 households. Today, right around half of all senior households are paying some sort of tax on their Social Security benefits.
Although the vast majority of seniors have called for an end to the taxation of benefits, or at the very worst an inflationary update to the qualifying thresholds, neither request is likely to be granted anytime soon.
Social Security is facing an estimated funding shortfall of a whopping $16.8 trillion over the next 75 years, according to the latest Trustees report. Though updating the taxation threshold, or eliminating the taxation of benefits completely, would put more money into the pockets of seniors in the short term, it would deprive Social Security of much-needed income, thereby expediting the time frame when benefit cuts may become necessary. With Social Security's asset reserves already expected to decline by close to $1.1 trillion over the next decade, the absence of the taxation of benefits would balloon this deficit to perhaps more than $1.7 trillion.
Even though failing to update the taxation of benefits to reflect inflation over the past 27 to 37 years can rightly be viewed as "unfair," lawmakers simply have no incentive to change things when every dollar is needed to support an already ailing program.