The income threshold that triggers federal income taxes on your Social Security benefits hasn't changed since 1984. Meanwhile, the national average wage index used by the Social Security Administration (SSA) to compute benefits has tripled since 1984, while the Consumer Price Index has risen nearly two-and-a-half times. As a result, more and more individuals and families are paying taxes on their Social Security benefits every year, not because their real incomes have risen significantly but mainly because of rising wage and price levels.
The government’s use of a fixed income threshold that is not adjusted for either inflation or rising wages amounts to both an ongoing stealth tax increase and a means test on Social Security beneficiaries, since taxing benefits based on your income effectively reduces them. About half of all families receiving benefits now pay income tax on them. In 1984, when benefits first became taxable, fewer than one in ten did.
Background: The Good Old Days
On January 31, 1940, Ida May Fuller, a legal secretary from Ludlow, Vermont, became the first person in the United States to receive an old-age monthly benefit check under the then-new Social Security law, which was enacted in 1935. She was 65 years old. The check was for $22.54. Her total contribution to Social Security, made between 1937 and 1939 during her years of participation in the program, was $24.75. Ida lived to be 100, and collected a total of $22,888.92 in Social Security benefits. That was a pretty good deal for Ida. Not only that, but Ida never paid a dime of income taxes on her benefits.
Enter the Tax Man
For 44 years, Social Security benefits were exempt from federal income tax. Starting in 1984, however, beneficiaries whose income exceeded certain thresholds were taxed on up to 50 percent of their Social Security benefits. In 1993 the law was further amended to tax up to 85 percent of Social Security benefits after slightly higher income thresholds are reached.
How to Determine Whether Your Social Security Benefits Will Be Taxed
How much, if any, of your Social Security benefits are taxable depends on whether your total income exceeds the “base amount,” or threshold, for your income tax filing status. For this purpose, the IRS defines your total income very broadly. Total income includes: (1) one-half of your Social Security benefits, plus (2) “[a]ll your other income, including tax-exempt interest.”
In figuring whether your Social Security benefits are taxable, “total income” also includes exclusions and adjustments that you’re otherwise permitted to take in arriving at your Adjusted Gross Income. These include interest from qualified U.S. savings bonds, foreign earned income and housing, and the deduction for student loan interest.
For a married couple filing a joint income tax return, up to 50 percent of their Social Security benefits are taxable if their total income exceeds $32,000. If their total income exceeds $44,000, up to 85 percent of benefits may be taxed. (For single persons and most other taxpayers, the thresholds are $25,000 and $34,000, respectively.)
How the Stealth Tax Increase and Means Test Happen
Under our progressive income tax system, tax rates increase as your taxable income increases. To keep people from automatically being pushed into higher tax brackets simply because of inflation, indexing of the income tax brackets for inflation was enacted under President Reagan in 1981, and took effect for tax years beginning in 1985.
When Congress made Social Security benefits taxable in 1984, however, the income threshold of $32,000 for married couples ($25,000 for most others) was not indexed to inflation in either wages or prices.
The result? In 1984, when the law went into effect, less than 10 percent of beneficiary families had to pay income tax on their Social Security benefits. Thirty-one years later, in 2015, a Social Security Administration Issue Paper projected that 52 percent of Social Security beneficiaries would pay income tax on their benefits that year. Among those 52 percent, the median share of benefits owed as tax was estimated at 11 percent.
In other words, those Social Security beneficiaries who paid taxes on their benefits had their benefits effectively reduced, half of them by more than 11 percent and half by less. A reduction in benefits based on your income, no matter what it’s called, is a means test.
To put this in perspective, if we adjusted the 1984 income threshold at which benefits become taxable to reflect average wage growth, using the Social Security Administration's average wage index table (which SSA uses to make past earnings comparable with current earnings), the $32,000 threshold for married taxpayers today would triple, to more than $96,000. The $25,000 threshold for single taxpayers and most others would exceed $75,000 before benefits were taxed.
Because the income thresholds that trigger taxation of Social Security benefits are fixed, a family today making about the same inflation-adjusted threshold income as a 1984 family pays tax on up to 85 percent of their Social Security benefits. The 1984 family paid no tax on their benefits. That amounts to a whopping tax increase.
Tax Planning Opportunities: Limited, but Still Available
If your total income is near the thresholds at which either 50 percent or 85 percent of Social Security benefits become taxable, one dollar of additional income can trigger a significant jump in your marginal tax rate.
Example: Nick and Nora are in the 12 percent federal income tax bracket. Every $1 of extra income they earn costs them 12 cents in taxes. But if that same extra dollar of income also causes 50 percent of a Social Security benefit dollar to become taxable, Nick and Nora must now pay tax at 12 percent on that 50 cents of taxable Social Security benefits, or 6 cents more (50 cents X 12%). Thus, one extra dollar of income now costs 18 cents in taxes (12 cents + 6 cents), and Nick and Nora’s marginal tax rate has now increased from 12 percent to 18 percent. Their marginal tax rate has increased by 50 percent!
Unfortunately, because the IRS definition of total income is so broad, opportunities for avoiding or reducing the tax on your benefits are limited. Most often, your only recourse is to pursue two traditional tax planning strategies—postponing income while accelerating or maximizing certain deductions that are taken in arriving at adjusted gross income (so-called “above-the-line” deductions). These include:
- Deferring the receipt of income—If you have the ability to postpone the receipt of income into next year, you may be able to reduce both your overall taxes and the taxable amount of your Social Security benefits this year. Examples of items that might potentially be deferred into next year include taxable IRA or 401(k) distributions (other than required minimum distributions), business income, or year-end bonuses.
- Harvesting capital losses—Capital losses that exceed capital gains can offset up to $3,000 of ordinary income. Thus, harvesting capital losses could potentially make less of your benefits taxable by reducing your total income.
- Maximizing allowable deductions and adjustments to income—Some above-the-line deductions are still allowed in arriving at your total income for benefits taxation purposes. These include IRA and Health Savings Account contributions, educator expenses, and various deductions available to self-employed people, such as the deductible part of self-employment taxes and the deductions for health insurance and retirement plans.
A combination of these planning techniques could be highly beneficial not only in reducing your overall taxes but also in avoiding the punitive jump in marginal tax rates that results when additional Social Security benefits become taxable.
Putting It All in Perspective
Congress’s goal in making Social Security benefits taxable was to make their tax treatment comparable to that of private pension income, which is generally taxable to the extent that payments exceed worker contributions. The Social Security Administration has estimated that the average worker directly contributed in taxes only about 15 percent of the benefits he or she receives. Accordingly, only up to 85 percent (100 percent minus 15 percent) of benefits are taxable. That avoids double taxation on the portion of benefit income that represents previous contributions.
Whether that calculus remains the same for the future, as changes to Social Security are contemplated, remains to be seen. Later retirement ages, higher limits (or no limits) on the earnings to which Social Security taxes apply, increased FICA tax rates, or lower benefits may argue for reducing the portion of benefits that are taxable.
It’s also important to remember that, for individuals and families with total income below the thresholds, all Social Security benefits continue to be tax-free at the federal level. Moreover, 37 states do not currently tax Social Security benefits.
Also note that the income taxes you pay on your Social Security benefits are credited to the Social Security and Medicare trust funds, which in turn helps to ensure that those programs continue to be funded.
Finally, the next time you hear someone proposing that Social Security benefits be means-tested, realize that, to a certain degree, they already are.