NCPA - National Center for Policy Analysis


June 7, 2006

The Social Security benefits tax affected less than one in 10 beneficiaries when it was first imposed. Today, however, it affects more than one of every five recipients. By the time the children of the baby boomers retire, almost all beneficiaries will be paying tax on some portion of their benefits, says Stephen J. Entin, president and executive director of the Institute for Research on the Economics of Taxation. Why? Because the thresholds at which the benefits tax is triggered are not adjusted for inflation, and more and more people will be subject to the tax as incomes rise over time.

About 60 percent of the income of elderly taxpayers comes from investments -- including pensions, Individual Retirement Accounts (IRAs) and 401(k)s. For most workers, 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).

To eliminate the odd effects of the Social Security benefits tax, Congress should repeal it, says Entin. 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.

Source: Stephen J. Entin, "Taxing the Elderly," National Center for Policy Analysis, Brief Analysis No. 555, June 6, 2006.

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