Ten Steps to Reforming Baby Boomer Retirement

Studies | Retirement

No. 283
Thursday, March 23, 2006
by John C. Goodman, Devon Herrick, Matt Moore


Step 5. Repeal the Social Security Benefits Tax

Figure III - Calculating Taxable Social Security Benefits for a Couple

The Social Security benefits tax inflicts some of the highest marginal tax rates in the federal tax code. Although nominally a tax on Social Security benefits, it is really a tax on other retirement income. Because of the benefits tax, the retirement savings of the vast majority of current and future retirees are much less valuable.

"The Social Security benefits tax penalizes workers who save for retirement."

How Benefits Are Taxed. Taxes are imposed on up to half of benefits for single retirees with modified adjusted gross incomes higher than $25,000 and for couples with incomes above $32,000.32 Affected retirees must add 50 cents in benefits to their taxable income for every dollar by which their income exceeds the threshold until half their benefits are subject to taxation. Thus, when retirees earn $1.00, they must pay taxes on $1.50. As a result, the marginal tax rate on their income is 50 percent higher than for young people with the same income.

As income rises, the tax becomes more onerous. Single retirees with incomes above $34,000 and couples with incomes higher than $44,000 must add 85 cents in benefits to taxable income for every dollar of income above these thresholds until 85 percent of their benefits are subject to the tax. [See Figure III.] Thus, when these retirees earn $1.00, they must pay taxes on $1.85. As a result, the marginal tax rate on their income is 85 percent higher than for young people with the same income.

Who Pays the Tax? When first imposed, taxation of Social Security benefits affected less than one in ten beneficiaries. Today, however, it affects more than one of every five recipients, and it will affect many more people in the future, because the tax thresholds are not adjusted for inflation. By the time the children of the baby boomers retire, almost all beneficiaries will be paying tax on some portion of their benefits.

Taxing Savings. About 60 percent of the income of elderly taxpayers comes from investments (including pensions). For most younger people, the tax rate on investment income is 15 percent or 25 percent. For the elderly, the Social Security benefits tax makes the effective rate much higher.

  • Elderly taxpayers in the 15 percent income tax bracket - and subject to the 50 percent benefits tax - pay an effective rate of 22.5 percent (15 percent x 1.50).
  • Elderly taxpayers in the 25 percent tax bracket - and subject to the 85 percent benefits tax - pay an effective rate of 46.25 percent (25 percent x 1.85).

Figure IV - Marginal Taxes on an Additional Dollar of Wage Income for an Early Retiree

"The marginal tax on seniors who work can reach 63 percent — or more!"

Taxing Wages. The Social Security benefits tax severely penalizes moderate-income elderly who collect early retirement benefits from Social Security and continue to receive wage income. As noted, the earnings penalty reduces Social Security benefits by $1.00 for every $2.00 of wage income earned above $12,480 per year (an effective marginal tax rate of 50 percent) for workers between age 62 and the normal retirement age.

Consider a single male whose earned income plus one-half his Social Security benefits equals $30,000. If he earns one additional dollar, he loses 50 cents of benefits, and he pays 15 cents in federal income taxes and 7.65 cents in FICA (Federal Insurance Contributions Act) payroll taxes. Since one-half of his previously tax-free Social Security benefits are now taxable, he pays an additional tax of 7.5 cents. Thus from each additional dollar of earned income, he nets less than 20 cents in spendable income. His marginal tax rate is 80 percent! [See Figure IV.]

The situation is far worse for retirees above the 85 percent benefits tax threshold. Consider the previous scenario, but with a single male whose earned income plus 85 percent of his Social Security benefit equals $60,000. His effective marginal tax rate is greater than 100 percent! (If he earns one additional dollar, he still loses 50 cents of benefits, pays 25 cents in federal income taxes, 7.65 cents in FICA payroll taxes, and 85 percent of his previously tax-free Social Security benefits are subject to taxation.)

Figure V - Marginal Tax Rates for the Middle-Income Elderly

"Retirees in the 15 percent tax bracket face a 22.5 percent marginal tax on income from savings."

Hidden Effects. Because of the way income tax returns are organized, many elderly taxpayers do not realize that the Social Security benefits tax actually taxes other income. And because many states accept the federal definition of taxable income, it increases some state and local income tax rates by 50 percent to 85 percent, depending on the income level.

Consider the effects for a single retiree in the 15 percent tax bracket whose post-retirement incomes raise them above the first threshold of the Social Security benefits tax, in which 50 percent of their benefits are subject to taxation. As Figure V shows:

  • Withdrawals from pensions and capital gains income are subject to a 22.5 percent rate for Social Security recipients versus 15 percent for others.
  • Tax-exempt income of the elderly can be taxed at a rate of 7.5 percent versus a zero rate for younger taxpayers.

Consider further the effects on a single retiree in the 25 percent tax bracket who is above the second Social Security benefits tax threshold. As Figure VI shows:

  • Withdrawals from pensions are subject to a 46.25 percent rate versus 25 percent for others.
  • Capital gains income is subject to a 36.25 percent rate versus 15 percent for others.
  • Tax-exempt income of the elderly can be taxed at a rate of 21.25 percent versus a zero rate for younger taxpayers.

Figure VI - Marginal Tax Rates for the Middle-Income Elderly

"Retirees in the 25 percent tax bracket face even higher marginal taxes on their income."

How the Social Security Benefits Tax Also Taxes the Young. As we have seen, the federal government grants a special tax status to employer-provided pensions, IRAs and 401(k) plans to encourage retirement savings. The law allows people to avoid taxes now and defer them until their retirement years on the assumption that most income will be taxed at lower rates after they retire. Yet that assumption is no longer true for many young workers because of the Social Security benefits tax. Thus, in a sense, the tax decreases the value of most American workers' retirement savings.

Solution: Tax Social Security Benefits as Ordinary Income. To eliminate the odd effects of the Social Security benefits tax, Congress should repeal it. If there is an argument for taxing these benefits, the correct way to tax them is to include a portion of them in ordinary income and subject them to ordinary income tax rates. Middle-income seniors would pay taxes on some portion of their Social Security benefits the same way they pay taxes on IRA withdrawals and pension benefits - at the same tax rate faced by younger taxpayers.


Read Article as PDF