Taxation of Social Security Benefits Contentious

taxes, tax, finance

Little in the IRS tax code draws more unfavorable response than the rules around the taxation on Social Security benefits.

By Brenton Smith

Little in the IRS tax code draws more unfavorable response than the rules around the taxation on Social Security benefits. As contentious as that feature of the system can be, it is here to stay. There is no way to replace that income.

History

These rules originate from the Social Security Reform Act of 1983. They were a major part of the changes that enabled Congress to assure voters of the time that the system was secure over the longer term. While these changes to the tax code brought in almost no money at the time, this component of the legislation was the largest aspect of the overall solution, accounting for roughly a one-third of the legislation’s effectiveness.

Why So Much

The math is simple. Since the rules did not create meaningful savings in the short-run, they had to generate substantial savings as time passes. The complaints about the tax are a result of that strategy.

Even back then, Congress knew three forces would enable this tax to reach a larger percentage of a larger pool of seniors who would pay taxes against a larger portion of their income. As a result, someone like Bernie Sanders pays today more than $16,000 in taxes on his benefits.

The problem at this point is these taxes hit more than Se. Sanders. Over time, these trends mean that people slightly over poverty level income are hit with the tax.

♦ The retirement of the Baby Boomers creates a larger number of beneficiaries who face the tax

♦ The trigger in formula is not indexed to inflation, meaning that a greater percentage of that larger pool would pay the tax

♦ Americans who use tax-deferred accounts appear as though they still have fulltime wage jobs. This means that greater amounts of benefits of more people are generating tax revenue.

Double Taxation 

(detail behind the SSA’s reasoning on the issue)

This question is theoretical, so you will have different people reach different conclusions. In my mind, this is double taxation. A pension generally restructures the timing of your paycheck. Instead of collecting the dollar in the year in which it was earned, the dollar of payment is received decades out. In this case, the wages were taxed in the year when you were paid, and pension is taxed in the year in which it is received. It is the same dollar-earned is taxed as income in two different years.

The Consequence

Originally, the point of these rules was to claw-back to benefits from people with substantial outside income. At this point, the IRS is collecting taxes from people who are marginally above poverty level income in 2017. Absent the end of inflation, we will soon specifically target those people who are in poverty for a tax that was intended for those with ‘substantial outside income.’

Vital Income

While these rules are unfair, counter-productive, and hopelessly complex, Congress has little option to address them because this revenue channel is vital to the system’s health. This is not only a rapidly growing source of revenue, but it is free cash flow.

It is important to understand that a dollar of income tax revenue is worth a lot more to the system than a dollar of payroll tax revenue. The latter generates expenses for the system in the form of higher benefits. First, the current worker may become a future retiree who collects benefits. Second, as average wages rise, the indexing aspect of the benefit formula pushes benefits higher today.

Moreover, this income tax revenue is projected to nearly triple to roughly $90 billion over the next decade. Today policy makers who are obsessed with the falling retiree-to-worker ratio should consider that such revenue approximates more than 20 million workers. The sums are expected to rise sharply because the cash flow is growing at three times the rate of the economy.

We have no comparable revenue base that grows this rapidly or efficiently.

Complicating Tax Reform

President Trump would love to love to reform taxes, except the taxation of benefits. The problem is that his approach would lower the amount of revenue collected for Social Security. If Trump’s plan becomes law, beneficiaries would in most cases pay a lower tax rate on a smaller amount of benefits. Such changes would in turn appear in the projections of the following year’s Trustees Report for the Trust Funds.

This outcome by itself does not make the case for Tax Reform wrong, but it would be welcome to see the Social Security Administration provide estimates on the impact so there isn’t a surprise.

Brenton Smith writes on all aspects of Social Security reform, translating the numbers and jargon of the issue into terms that everyone can understand. His work has appeared in Forbes, MarketWatch, Fox Business, The Hill, and a number of regional newspapers. To read more of his reports — Click Here Now.

This article originally appeared on FedSmith.Com

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