For many Americans, Social Security already is, or will become, an important part of their monthly income during retirement. According to annual surveys conducted by Gallup over the past two decades, Social Security payouts have represented a "major" source of income for at least 54% of respondents in all but one year.
For decades, this top-tier retirement program has done a fantastic job of pulling aged Americans out of poverty and providing some form of financial floor for retirees. Unfortunately, it's also a program that continues to inch closer to disaster.
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Social Security is staring down a $20 trillion abyss
Every year since payments began to retired workers in 1940, the Social Security Board of Trustees has issued a report that outlines the short-term (10-year) and long-term (75-year) outlook for the program. This usually 200-plus page report takes into account a myriad of economic and demographic shifts to determine how "healthy" Social Security is from a financial perspective.
Since 1985, this annual report has served as a warning that Social Security is estimated to have insufficient revenue to cover its outlays (i.e., benefit payments) over the long run. The 2022 report estimates a $20.4 trillion cash shortfall through 2096, with more than a half-dozen factors contributing to this deficiency.
Most importantly, the latest Trustees report lays out the case for the Old-Age and Survivors Trust Fund (OASI) to exhaust its assets reserves -- its excess cash built up since inception -- by 2034. The OASI is what parses out payments to more than 48 million retired workers each month. If these assets reserves become depleted, a 23% across-the-board benefit cut may be necessary to sustain ongoing payments through 2096.
There are pretty much only two levers to pull when it comes to "fixing" Social Security's imminent cash shortfall: raise additional revenue or reduce costs. Since most folks aren't thrilled about the prospect of reducing monthly payouts or lifetime benefits, raising revenue is where the pendulum often swings.
This hated revenue source will become more important over the next decade
Last year, Social Security brought in a little over $1.08 trillion in revenue from three sources. The 12.4% payroll tax on earned income accounts for the lion's share of revenue. Last year, it generated 90.1% of the $1.08 trillion collected.
The second revenue source is net interest income, which accounted for $70.1 billion in revenue. The program's asset reserves are required by law to be invested in special-issue government bonds and certificates of indebtedness. The interest earned on these bonds and certificates of indebtedness help to fund Social Security benefits.
US Old-Age, Survivors, and Disability Insurance Trust Fund Income from Taxation of Benefits Receipts data by YCharts. The $40.7 billion annotated on the chart is for 2020, per the Trustees report.
Lastly, there's the most controversial revenue source: the taxation of benefits.
Back in 1983, with the program's asset reserves nearly depleted, then-President Ronald Reagan signed into law the last bipartisan overhaul of Social Security. In addition to gradually raising the payroll tax and full retirement age, it introduced the taxation of Social Security benefits, which took effect in 1984.
When first introduced, up to 50% of benefits could be exposed to federal taxation if a person's modified adjusted gross income (MAGI) plus one-half of benefits surpassed $25,000 (or $32,000 for a couple filing jointly). In 1993, the Clinton administration added a second tier that allowed up to 85% of benefits to be federally taxed if the MAGI plus one-half benefits formula crossed above $34,000 for a single-filer or $44,000 for a couple filing jointly.
Last year, the taxation of benefits brought in $37.6 billion, or 3.5% of total revenue. By 2031, the intermediate-cost model (i.e., the cost model the Trustees believe is likeliest to occur) projects the taxation of benefits will account for $112.7 billion in revenue, or 6.3% of projected full-year revenue for Social Security.
Over the next decade, the taxation of benefits is forecast to generate $775 billion in revenue.
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The taxation of benefits is Social Security's necessary evil
To say that the taxation of benefits is despised by seniors might be an understatement. Five years ago, The Seniors Center polled retirees on ways to "relieve the burden of rising cost-of-living for seniors." A whopping 91% of respondents suggested that no longer taxing Social Security benefits would be a smart move.
The single biggest issue with the taxation of Social Security payouts is that the aforementioned income thresholds subjecting beneficiaries to taxation have never been adjusted for inflation. Every cost-of-living adjustment passed along to the program's beneficiaries leads to more and more recipients being hit with federal taxation on what they receive. According to The Senior Citizens League, in the neighborhood of half of all households receiving a Social Security payout may pay some amount of tax on their benefits this year.
However, this disliked revenue source is unlikely to go away anytime soon, if ever, for two key reasons.
First of all, Social Security needs all the revenue it can get to avoid having its already massive $20.4 trillion long-term cash shortfall further widen. This means not only continuing to collect tax on benefits paid over certain income thresholds, but ignoring the lack of inflationary adjustments to the income thresholds after multiple decades.
The second issue is that removing the taxation of benefits would require bipartisan support in the Senate, which has been virtually impossible to come by for Social Security in decades. Although there are a couple of program shortcomings Democrats and Republicans agree exist, the two parties have approached fixes from opposite ends of the spectrum and have been unwilling to meet their opposition in the middle.
Given the financial state of Social Security, the taxation of benefits is a necessary evil that's only going to grow in importance over the next 10 years.
