Categorized | Retirement, Features, Your Money

What Tax Reform Means for Your Social Security Benefits

social security, money, retirement

Yes, your taxes on Social Security benefits are going to rise over time as a result of tax reform. That is clear even if the explanation is a little cloudy.

By Brenton Smith

Yes, your taxes on Social Security benefits are going to rise over time as a result of tax reform. That is clear even if the explanation is a little cloudy.

Social Security does not operate in a vacuum as many people believe. If legislation affects wages, Social Security will be affected even though the words Social Security never appear in the text. If Congress changes tax rates as it did last year, Social Security will be affected.

The tax reform package passed last year incorporates a technical change that will yield an oblique benefit cut. Specifically, the legislative changed the way tax brackets move to sync with Chain-CPI rather than the standard price index. Long story short, future seniors will pay more taxes on Social Security benefits than they would under current law.

Every year, the IRS adjusts the mechanics of the tax code to prevent people from rising into higher tax brackets as a result of inflation rather than an increase in actual income. The tax reform package passed last year slows these adjustments for things like tax brackets and eligibility for deductions. The slower that these adjustments move, the higher taxes Americans will pay.

Initially, the new tax code will apply lower tax rates. That discount will however dissipate over time because the new tax brackets will typically grow more slowly. As a result, individual taxpayers, particularly in the middle class, will rise through tax brackets more quickly in a phenomenon known as “bracket creep.”

Howard Gleckmanof the Urban Institute observes that tax payers will barely notice this hidden levy for the first few years.  That tax presence grows however. He continues to point out that in the 10 to 20 year time table this change will be one of the biggest revenue-raisers for the government in the entire reform package. So the lower tax rates will go away over time.

How Tax On Social Security Works

Gleckman, of course, is talking about all taxes. But his analysis can be applied to the taxation of Social Security benefits. Here’s how that tax on Social Security works. Every dollar in income that a senior earns above the threshold exposes another $0.50 to $0.85 to taxation.  For someone in the 25 percent tax bracket, that means earning a dollar of incremental income can generate a tax of $0.46, or a 46.25 percent tax rate. So shifting tax brackets will have a shock value for future retirees.

If you want to see how “bracket creep” works in the extreme, Social Security’s threshold for taxation of benefits is one of the few tax provisions in the entire tax code not adjusted for inflation — at all.  When the tax was created in 1983, it was expected to affect only 3 percent of retirees. Today, it affects closer to 50 percent, and that figure will continue to rise.

These taxes aren’t going away because the revenue is vital to the program’s health. It is cheap cash that is growing rapidly. Unbeknownst to most, the revenue collected from the taxation of benefits is recycled into Social Security and Medicare. This money is very different from payroll tax revenue, which creates future obligations in the form of future benefits. This is free cash flow.

Moreover, its growth is staggering. It is increasing at a rate more than three time the growth rate of the nation’s GDP.  The trustees of the program believe that this revenue channel will grow over the next 10 years to nearly $100 billion. In the longer-term, we were on-pace to recycle a dime of every dollar paid in benefits — and that was before higher taxes were enacted.

This growth stems from the rising percentage of retirees who are exposed to the tax through bracket creep. The thresholds for paying taxes on Social Security haven’t changed since 1984. At that time, the law exempted people who earned less than $25,000, a sum that equates to more than $60,000 today. In total, you have more retirees, paying higher rates, on more income.

This revenue is vital to the programs financial health. So when you put all of these factors together, you find that a foundation of Social Security will depend upon future retirees getting less and giving up more.

Brenton Smith writes on all aspects of Social Security reform, translating the numbers and jargon of the issue into more understandable terms. 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.

 

Leave a Reply