Election season is in full swing now, with candidates trying to win voters by proposing ways to improve America. One big issue is Social Security, with many GOP candidates interested in reducing benefits and Democratic candidates offering ways to shore up the program and even strengthen it. One suggestion put forth by Hillary Clinton will likely worry some investors: making investment income taxable.
The big picture
Here's what that means: Right now, your income from work is taxable according to a schedule of tax brackets, with most Americans in the 25% or 28% tax brackets and the highest earners facing a rate close to 40%. (Of course, whatever tax bracket you're in doesn't represent the overall tax rate you pay. Thanks to deductions, credits, and progressively higher tax rates on increasing levels of income, your overall tax rate is likely considerably lower than your tax bracket.) Investment income such as long-term capital gains and dividend income gets a different -- and better -- tax rate, though. It's taxed at 15% for most of us, and 20% for high earners. Short-term capital gains are taxed at ordinary income tax rates.
So what is Secretary Clinton suggesting? Well, she has said that she would consider taxing investment income through Social Security withholding tax in order to generate additional funding for the program. Right now, workers pay a 6.2% tax on their income for Social Security, with their employers kicking in an additional 6.2%, for a total of 12.4%. (Self-employed folks pay the whole 12.4% themselves.) This applies to income up to $118,500 (for 2015 and 2016). Income above that level faces no Social Security tax.
"That's not fair!"
The tax situation above strikes some as unfair. That's because those with taxable incomes of $118,500 or less -- which is most of us -- pay Social Security taxes on all our income, while those who earn more, only have the tax applied to some of their income. If you earn $1,118,500, for example, you will pay the Social Security tax on your first $118,500, but not on the next million dollars.
For that reason, many have called for either raising that income cap considerably or eliminating it entirely. All three Democratic candidates, Hillary Clinton, Bernie Sanders, and Martin O'Malley, for example, support lifting the payroll tax cap. Even if there were no cap, though, and someone with taxable income of $1,118,500 were taxed on all of that, investment income would still be treated differently.
That's another aspect of our current tax system that seems unfair to many people, since poorer taxpayers tend to not have much or any investment income that gets the lower tax rate while many rich people receive much of their income in the form of dividends and capital gains. Enter Secretary Clinton's suggestion -- calling for both kinds of income to support the Social Security program.
Keep in mind
Clinton's suggestion might seem alarming to those with investment income, but remember that there's no guarantee that it will come to pass. She has not promised to tax it, and even if she had, politicians' promises are not always followed through on. Also, she has not been elected at this point, either. And her wording has left the tax expansion as just a possibility. Here's the relevant passage from her campaign website:
Preserve Social Security for decades to come by asking the wealthiest to contribute more. Social Security must continue to guarantee dignity in retirement for future generations. Hillary understands that there is no way to accomplish that goal without asking the highest-income Americans to pay more, including options to tax some of their income above the current Social Security cap, and taxing some of their income not currently taken into account by the Social Security system.
It's likely that in the coming years, some changes will be made to Social Security that will either strengthen it or reduce benefits. Most of us would do well to pay attention to such proposals and developments, because Social Security is a vital income stream for many millions of Americans and it's likely to be important for you, too. Fully nine out of 10 folks 65 and older receive benefits, and it makes up about 39% of their income, on average. Among single retirees, 74% get more than half their income from Social Security. For a sobering 22% of married retirees and 47% of single ones, Social Security checks make up at least 90% of their income.
As you learn more about the candidates vying for the presidency, be sure to give some thoughts to their Social Security positions and proposals.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.