Changing the Income Tax Treatment of Social Security Benefits
Recipients pay personal income taxes on their Social Security benefits if their incomes exceed certain levels. (The rationale for partially taxing Social Security benefits stems from the fact that while workers’ Social Security payroll tax contributions are included in gross income and thus subject to income tax during working years, employers’ Social Security payroll tax contributions are not.)
Boosting the income taxes beneficiaries pay could improve the system’s financing but would effectively reduce the returns certain earners receive on their payroll tax contributions.
Before 1984, Social Security benefits were exempt from taxation.
Today, those with higher incomes must pay personal income tax on their Social Security benefits (see IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits, or Social Security Administration 2009).
Those with less than $25,000 of “combined income” per year for a single person (including heads of household, usually unmarried people with dependents) or $32,000 per year for a married couple filing jointly do not need to pay any tax on their Social Security benefits.
- "Combined income" is defined as adjusted gross income (AGI) plus nontaxable interest plus half of OASDI benefits.
- Most married people who file their taxes separately from their spouses need to pay taxes on their OASDI benefits.
Those single people with combined income between $25,000 and $34,000 per year and those married couples filing jointly with income between $32,000 and $44,000 may need to pay tax on up to half their benefits.
Single people and heads of household with income above $34,000 and married couples (who file taxes jointly) with income over $44,000 may need to pay tax on up to 85 percent of benefits.
The income thresholds for determining the taxable fraction of benefits are not indexed for inflation, so a growing share of beneficiaries pays personal income taxes on their benefits each year (see, for example, Burman and Saleem 2004).
- In 2004, about 36 percent of beneficiaries were paying income tax on their benefits.
- The Tax Policy Center projects that about 40 percent will be paying tax on their benefits by 2014.
The actual amount of tax that individuals or couples pay on their benefits depends on their filing status and their tax rate, itself a function of their incomes.
In 2007, the Social Security Trust Funds received almost $18.6 billion in revenue due to the taxation of Social Security benefits. This amounted to about 3 percent of Social Security income (not counting interest). OCACT projects that by 2050, income tax revenue will make up more than 6 percent of income (Board of Trustees 2009).
One way to change the taxation of benefits would be to tax Social Security more similarly to the way that the government now taxes many employer pensions.
For such pensions, the part of the pension that the employee did not contribute to is subject to personal income tax (see, for example, IRS Publication 575, Pension and Annuity Income).
Those who made no contributions to the pension thus pay tax on the entire benefit amount.
Applying this type of logic to Social Security, the fraction of the OASDI benefit that the employee’s payroll tax contributions funded would be exempt from tax, while the fraction attributable to the employer payroll tax share or other cross-subsidies implicit in the system, like a spouse or survivor benefit, would be taxable.
The fraction the employee has contributed could be calculated based on summed nominal payroll tax divided by unisex life expectancy (with the calculation made at the time of Social Security claiming).
The calculation would be more complicated for married people who file joint returns, given that income taxes are based on the couple’s combined income.
To calculate net Social Security benefits each year, one subtracts the average annual contributions figure from the benefit. Total taxable Social Security benefits include the lower of 100 percent of net benefits or the sum of AGI, tax-exempt interest, and Social Security benefits greater than the specified thresholds.
Other forms of income are not taxed as favorably as Social Security. Fairness concerns thus led to the taxation of Social Security benefits starting in 1984 (DeWitt 2001 provides a history) and may argue for further refinement of benefit taxation.
A second rationale for changing Social Security’s tax treatment is to simplify the tax system. As described above, under current law the calculation of the taxable portion of Social Security can be confusing. However, some proposals could conceivably make the calculation of the taxable portion of the Social Security benefit more, rather than less, complex.
Moon and Mulvey (1996) and Goodman and Liebman (2008), among others, provide an additional rationale for favoring taxation of benefits over other types of benefit reductions. The central argument is that using a broader income measure, like adjusted gross income, better reflects individual economic circumstances and consumption than measures like Average Indexed Monthly Earnings and the Primary Insurance Amount, which are traditionally used when designing many Social Security changes. This could allow for better targeting.
Higher income taxes on Social Security benefits could reduce incentives to continue working later in life.
Higher and middle-range earners would get lower returns from their Social Security payroll tax contributions, possibly undermining political support for the system.
Social Security’s actuaries project that taxing Social Security benefits like a private pension (while gradually phasing out the lower taxation threshold) would reduce between 14 and 16 percent of the system’s imbalance over the 75-year horizon depending on how quickly the phase-out occurred (OACT 2009).
Distributional effects of this type of tax change would vary based on the specifics of a plan, and could lead to a mixture of winners and losers. When taxing Social Security like a pension, effects would likely be the greatest on those who a.) are above the income threshold for filing income taxes (the sum of the standard deduction and personal exemption) but below the current law threshold for paying taxes on Social Security benefits or b.) below the upper threshold (and thus paying taxes on a lower fraction of benefits).
For the 2008 tax year, the personal income tax filing thresholds were set as follows:
Those receiving auxiliary only--rather than worker or dual entitlement benefits--might also feel relatively large effects, as their entire benefit may be subject to income tax.
Certain higher earning beneficiaries may feel substantial absolute effects from the change, but in relative terms their losses may be more modest than others’ because they pay high payroll taxes relative to their benefits received (because of the lower replacement rate for higher lifetime earnings in the benefit formula). Indeed, some moderate and high earners may actually pay lower income taxes under this option than under current law.
Several prominent proposals designed to return the system to long-run fiscal balance would change Social Security’s tax treatment, including the following:
- All three of the plans advanced by the 1994–1996 Advisory Council on Social Security (1997) discussed adjustments in benefit taxation.
- A plan by Social Security Advisory Board member Mark Warshawsky (2009) includes a provision to tax Social Security more like a private pension. This proposal is evaluated in a memorandum on the Social Security Actuaries’ website (Goss et al. 2008).
The President’s Advisory Panel on Federal Tax Reform (2005), which did not aim to improve Social Security’s long-term financing, suggested a method for simplifying the tax treatment of Social Security benefits as part of a package of many changes to the tax code.
- Their proposal would involve taxing 85 percent of Social Security benefits for everyone (not just the higher-income beneficiaries), while at the same time increasing the standard deduction for all beneficiaries.
The taxation of Social Security benefit is a frequent target of Congressional legislation. In the 111th Session, bills that propose to eliminate benefit taxation or reduce the fraction of benefits that is taxable include H.R. 161, H.R. 162, H.R. 541, H.R. 883, H.R. 1058, and H.R. 1519.
See the Following Reports to Learn More:
Burman, Leonard E. and Mohammed Adeel Saleem. 2004."Taxable Social Security Benefits"
Butrica, Barbara, Karen E. Smith, and Eric Toder. 2008. "How the Income Tax Treatment of Saving and Social Security Benefits May Affect Boomers' Retirement Incomes."
Other References:
Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance [OASDI] Trust Funds. 2009. "2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds." Washington, DC.
DeWitt, Larry. "Taxation of Social Security Benefits." Research Note #12. Historian’s Office. Available at: http://www.ssa.gov/history/taxationofbenefits.html.
Goodman, Sarena and Jeffrey Liebman. 2008. "The Taxation of Social Security Benefits as an Approach to Means Testing." Paper presented at the Annual Conference of the Retirement Research Consortium.
Goss, Stephen C., Alice H. Wade, and Christopher J. Chaplain. 2008. "Estimated Financial Effects of 'A Reform Proposal to Make Social Security Financially Sound, Fairer, and More Progressive.' " Memorandum to Mark Warshawsky, dated September 17. Available at: http://www.ssa.gov/OACT/solvency/index.html.
Moon, Marilyn and Janemarie Mulvey. 1996. Entitlements and the Elderly: Protecting Promises, Recognizing Realities. Washington, DC: Urban Institute Press.
Office of the Chief Actuary (OCACT), Social Security Administration. 2009. "Provisions Affecting Taxation of Benefits." Available at: http://www.ssa.gov/OACT/solvency/provisions/taxbenefit.html
President’s Advisory Panel on Federal Tax Reform. 2005. Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System. Available at: http://www.taxreformpanel.gov/final-report/.
Social Security Administration, Office of Policy. 2009. Annual Statistical Supplement 2008 to the Social Security Bulletin. Washington, DC: Author.
Social Security Advisory Council, 1994-1996. 1997. Report of the 1994-1996 Advisory Council on Social Security. Volume I: Findings and Recommendations. Washington DC.
Warshawsky, Mark. 2009. "A Pro-Growth and Progressive Social Security Reform Proposal." Tax Notes 122(2): 283-284.
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