Please ensure Javascript is enabled for purposes of website accessibility

This 1 Flaw in Social Security Means More Retirees Pay Taxes Every Year

By Christy Bieber – Sep 10, 2020 at 9:15AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Here's how to avoid losing your benefits to the IRS.

Social Security benefits are earned benefits. Your payroll taxes support the program and you receive benefits as a retiree based on what you earned over your career. Because of that, you may be surprised to discover some of your benefits from this program may be taxable. 

It didn't use to be this way. But reforms in 1983 made up to 50% of benefits taxable for those with countable income above a certain level. And further reforms a decade later added a second layer of taxes, making up to 85% of benefits taxable for higher earners. 

But here's the problem: In both 1983 and 1993, when lawmakers determined how much income you could earn before your benefits become taxable, they did not index the amount to inflation. The income thresholds haven't been raised since, and probably won't be anytime soon. That has serious consequences for retirees. 

1040 Form with Check Sitting On Top of It.

Image source: Getty Images.

A stealth way of raising taxes

When lawmakers impose a tax at a certain income level but don't index it to inflation, this is a stealth way of raising taxes without having to take an uncomfortable vote to collect revenue from more retirees.

Wages and Social Security benefits both increase over time, which means retirees end up with more income on paper. But since the costs of goods and services also rise, they don't actually have much (if any) additional spending power. Yet, since more retirees have those higher incomes, more of them are subject to taxation. 

Under the current rules, singles could be taxed on up to 50% of their benefits once their countable income hits just $25,000 per year and could owe tax on up to 85% of benefits once it hits $34,000. Countable income includes half of Social Security benefits plus all taxable income and some nontaxable income such as municipal bond interest. Married couples are taxed on up to half their benefits with countable income above $32,000 and up to 85% with countable income above $44,000. 

As you can see, those income limits really aren't very high. Because of that, it's not surprising that around 50% of retirees now face taxes on their Social Security benefits. That's up from around 10% of retirees who were assessed the tax when it was introduced. And the number of retirees subject to this tax is only going to continue increasing as benefits rise slowly over time due to wage growth. 

How can you protect your retirement benefits?

If you're concerned about becoming one of the majority of retirees likely to owe taxes on your Social Security benefits in the future, you don't have to just accept this as your fate.

Instead, you can invest most or all of your retirement savings in a Roth 401(k) or Roth IRA if your company doesn't offer one. Just be sure to put enough into your 401(k) to get your full employer match first if you opt for a Roth IRA. 

Distributions from these Roth accounts are not considered taxable income, and they aren't part of your countable income for purposes of determining if your Social Security benefits are taxed. You can withdraw as much as you want from your Roth accounts and, as long as your income from other sources (including half your Social Security benefits) doesn't put you above the income thresholds listed above, you won't be taxed on your retirement benefits.

Of course, you also won't be taxed on you Roth distributions, either, as tax-free withdrawals are a key feature of these accounts. That makes them an optimal choice if you think your tax rate may be higher as a retiree, as well as a good way to make sure this serious flaw in Social Security doesn't leave you with less money in your later years. 

The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
331%
 
S&P 500 Returns
106%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 10/05/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.