Send me real-time posts from this site at my email
Motley Fool

Why Are Social Security Benefits Taxable?

Whether you realize it or not, Social Security truly is an incredible program. Each month, it's doling out almost 64 million benefit checks that are ultimately being leaned on by more than 15 million retired workers to pull themselves out of poverty. These monthly payouts also go to the survivors of deceased workers and the long-term disabled, many of which might struggle to make ends meet without this guaranteed financial lifeline.

But what you might be surprised to learn as a retired worker, or perhaps a future retiree, is that your Social Security benefit may be taxable. Why, you ask? That's not a simple answer, so let's dig into some of the history behind why the tax on benefits was introduced, as well as discuss why (unfortunately) it's not going away anytime soon.

Image source: Getty Images.

The history behind the taxation of Social Security benefits

The path to taxing Social Security benefits begins all the way back in the 1970s. When the 1970s began, Social Security's trust fund ratio -- a measure of a year's projected costs that could be paid with funds available at the beginning of the year -- stood at a relatively healthy 103%. But things quickly went downhill as demographic changes took shape.

By 1975, the program was expending more than it was bringing in each year, a trend that would continue through 1982. By 1982, the trust fund ratio was down to a meager 15%. In other words, Social Security was running on fumes, and while the program can't go bankrupt, it was very close to a point where across-the-board benefit cuts would have needed to be instituted to maintain solvency. With so many Americans reliant on Social Security income to make ends meet, benefit cuts weren't viewed as a viable solvency option. Thus was introduced the last major bipartisan Social Security overhaul, the Amendments of 1983.

The Amendments of 1983 made a number of changes to the Social Security program, with each political party able to have their core "fix" implemented. For example, Republicans who wanted to see long-term program expenditures reduced were able to include a two-year increase to the full retirement age over the next four decades. By 2022, the full retirement age will peak at age 67 after having been age 65 for many decades. Meanwhile, Democrats were able to include provisions designed to boost revenue collection, including a gradual increase to the payroll tax of all working Americans.

However, one of the more controversial additions to the Amendments of 1983 was the introduction of taxing Social Security benefits, which was officially implemented in 1984. This tax, which was originally designed to only impact upper-income senior households, was introduced to help raise additional revenue and avoid having to cut retired-worker benefits.

Image source: Getty Images.

Will you be taxed on your Social Security benefit?

The next question that typically comes to mind when you tell current or future retirees that Social Security benefits are taxable is, "Will my benefits be taxed? Right now, the answer is pretty much 50-50 between yes and no, although the pendulum continues to swing more toward seniors being taxed than not being tax on their Social Security income.

In 1984, when the taxation of benefits was implemented, persons and couples filing jointly whose modified adjusted gross income (MAGI) plus one-half of benefits exceeded $25,000 and $32,000, respectively, were subject to the tax. In this instance, the tax meant that up to half of their Social Security benefits could face federal ordinary income tax rates.

Then, in 1993, a second tier of taxation was introduced under the Clinton administration. Using the same formula as above -- i.e., MAGI plus one-half of benefits -- single filers and couples filing jointly with more than $34,000 and $44,000, respectively, will be subjected to this second tier. This new tier allows up to 85% of Social Security benefits to be taxed at the federal ordinary income tax rate.

Now, here's the catch: These income thresholds have never been adjusted for inflation. The fact that these thresholds haven't budged for 35-plus and 25-plus years, respectively, is a big reason why more and more seniors are being subjected to this tax, and why you currently are, or may be in the future, paying back some of your benefits to the Social Security Administration.

Image source: Getty Images.

Sorry, folks, but the taxation of benefits is here to stay

To be crystal clear, there aren't many people that like this tax, as it's often viewed as a means of being double taxed (even though this isn't entirely accurate). Nevertheless, even with overwhelming public support to shelve the taxation of benefits, it's not going to happen.

The reason? Social Security is, once again, facing an imminent cash shortfall. Despite what looks to be a healthy trust fund ratio of 289% as of 2018, the Social Security Board of Trustees has forecast that the program's nearly $2.9 trillion in asset reserves will be completely gone by 2035. If Congress were to fail to act, this would lead to an across-the-board benefit cut for retirees of up to 23%. To just lay this out in a no-nonsense way, Social Security needs all the revenue it can get right now.

If lawmakers were to end the taxation of benefits, it could definitely lead to a modest boost in income for middle-class and upper-income retired individuals and couples. However, it would be removing quite a bit of money from Social Security each year. Last year, the taxation of benefits accounted for $35 billion of the $1 trillion collected, and over the next decade an estimated $596 billion will be collected by the Social Security program solely from taxing benefits. Removing this income from the equation would only speed up the process by which Social Security's asset reserves would be exhausted, thereby leading to even quicker across-the-board benefit cuts.

Worse yet, adjusting these income thresholds for inflation is off the table, too. With the program needing as much income as possible to thwart/stall what looks to be an inevitable cash shortfall over the long run, reducing the income received from taxing benefits by adjusting these thresholds isn't an option lawmakers are seriously considering right now.

Despite being a hated tax, the taxation of Social Security benefits isn't going anywhere.

The $16,728 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.


Source

Popular posts

Welcome!!! Is it your First time here?

What are you looking for? Select your points of interest to improve your first-time experience:

Apply & Continue