The 2016 presidential elections are bringing a number of issues to the forefront, but for our nation's nearly 50 million older Americans, and the tens of millions of pre-retirees expected to hang up their work gloves in the coming years and decades, perhaps nothing is more important than the future of the Social Security program.
Social Security has been primarily providing income for America's retired workers for more than 75 years, but it also provides income to workers who've become disabled and are unable to work, as well as immediate family members of deceased, but eligible, workers. Without the monthly income provided by Social Security, there's no telling how many millions of seniors would be struggling to meet their monthly basic-need expenses.
Of course, Social Security has problems of its own. The Social Security Board of Trustees' report from last year projects that the Old-Age, Survivors and Disability Insurance Trust Fund will burn through its excess cash reserves by 2035 if Congress fails to find a way to bring in more revenue, cut benefits, or enact some combination of the two. The blame for this cash shortfall appears to rest with our changing demographics. Boomers are retiring in greater numbers, causing a shift lower in the worker-to-beneficiary ratio, and people are living longer than ever, which allows for a longer drawdown of benefits.
Social Security's age-old problem
But, this is far from the only issue. A concern that's been percolating for about three decades looks to sap seniors of their buying power during retirement.
In 1983, Congress passed a series of amendments to Social Security. Among these amendments were a series of federal income taxes that could be imposed on beneficiaries if their modified adjusted gross income (MAGI) exceeded specific thresholds. You can see the tax schedule below using MAGI income figures.
For individuals, income below $25,000 is considered exempt from taxation. Any earned income between the $25,000 and $34,000 threshold in a given year could require a tax on up to 50% of an individuals' Social Security benefits. Should an individual earn in excess of $34,000 in income, up to 85% of his or her benefits become taxable.
For couples the same idea applies, although the values are logically a bit higher. Income below $32,000 for couples is considered untaxable in a calendar year. If a couple was to earn between $32,000 and $44,000 in income, up to half of their Social Security benefits could be taxed. Any more than $44,000 in annual income and the federal government can tax up to 85% of their Social Security benefits.
When these amendments were passed in 1983 and first implemented in 1984, these income tax thresholds were only designed to affect about one-in-10 Social Security beneficiaries. But here's the thing... lawmakers haven't adjusted the income thresholds for 33 years. A report from The Senior Citizens League suggests that if the federal government had kept the thresholds in-line with the rate of inflation, the exemption threshold for individuals should be $57,107 in 2015 dollars and $73,097 for couples. That's a big variance, and it's a big reason why seniors may be parting with more of their money due to federal taxes than they expected when they entered retirement.
Yet, the scariest thing of all is that this problem is only expected to get worse.
Here's how many beneficiaries might owe tax on their benefits
According to a report released by author Patrick Purcell of the Social Security Office of Retirement and Disability Policy in December 2015, a MINT microsimulation model, or Modeling Income in the Near Term (MINT), suggests that the percentage of beneficiaries who owe tax on their Social Security benefits is going to rise into 2030.
As you can see above, in 2010 about 72% of Social Security beneficiaries were required to file a tax return. We can also see that 47.1% of Social Security beneficiaries owed some form of tax on their benefits received. As time passes, though, this figure is expected to rise. The report notes that by 2030 some 58% of Social Security recipients -- nearly three-in-five -- will pay federal income tax on a percentage of their benefits. The very modest drop after 2030 is based on "the assumption of both the change from price indexing to wage indexing for tax brackets and a slowing rate of growth in retirement income from nonbenefit sources," according to the report.
However, if there is some solace here it's that income taxes on benefits will predominantly affect families that presumably can afford to pay tax on their benefits.
As you can see below, when breaking out Social Security benefit income by percentiles, the bottom 25% in terms of benefits received won't owe a dime in taxes on their benefits through 2050. The 90th percentile, along with the 75th percentile, will see modest increases in the percentage of income tax owed on their benefits. For instance, the 90th percentile will go from paying 15% of their benefits as income tax in 2010 to about 17.3% by 2050. The biggest jump will come from the 50th percentile, or the middle-class retired family, which is estimated to go from paying no income tax on their Social Security benefits in 2010 to as much as 4.8% of their benefits as income tax by 2050.
This represents a potentially worrisome scenario for this middle-class benefit-income percentile, especially with the prospect of benefit cuts being a genuine possibility to keep the program solvent.
Make sure you have a Plan B in place
Just to make things even more complicated, there are also 13 states that tax Social Security benefits. The good news is nine of these 13 states offer income exemptions up to certain levels, with some, like Missouri, having very generous annual income exemption thresholds of $85,000 in adjusted gross income per individual and $100,000 in AGI for couples. However, four states -- Minnesota, Vermont, West Virginia, and North Dakota -- tax Social Security benefits without any exemptions, meaning it mirrors that of the federal government.
As if there weren't enough reasons why Americans should work to lessen their reliance on Social Security, take this report as just another kick in the pants that other sources of income are going to be critical when you retire. Social Security income is only expected to replace about 40% of your working wages, so that's a good figure to keep in your head when planning for retirement and working out your monthly budget.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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