Tax Reform Recommendation
By Gary A. Hensley, MBA, EA
As we begin another season of watching political candidates aspire to the presidency, we will be smothered with ideas about how to “save” federal trust funds such as Social Security. Due to the ever-increasing senior citizen demographic (those 62 and older for our purpose here), most candidates will be loath to suggest anything that would impinge on their future benefits (at least until another election has passed). From a strictly political perspective, it’s irresponsible to discuss any type of funding source reduction. Which is another way of saying you will likely only see this point-of-view here.
It’s a two-edged sword—to give seniors more disposable income by not taxing their Social Security benefits is helpful to them, but at the same time it reduces those dedicated tax dollars from going into the fund to preserve its future financial integrity. Ending the taxation of Social Security benefits, however, will have a negligible effect on the final solution needed to shore up the major funding issues associated with Social Security (for example, there are now only two workers for each Social Security retiree) but will have an immediate positive impact on seniors struggling with rising health care costs, food, gasoline, rent or mortgage payments, etc.
For 2011, the most recent year of income by source data available from the IRS, total Social Security benefits reported were $490.7 million (25.8 million returns) and $201.6 million of this was taxable (16.8 million returns). More specifically, for the adjusted gross income range of $25,000 to $75,000, the taxable Social Security benefits totaled $84.3 million (9 million returns). In 2015, single filers could pay as high as 25% on their taxable benefits in this range and married couples 15%.
The taxation of Social Security benefits debuted, in 1984 (Code Sec. 86), during Ronald Reagan’s presidency and was capped at 50% of benefits received. In 1993, the tax cap was raised to 85% of benefits received under President Bill Clinton. Thus, it has been a bipartisan effort to get where we are today.
In 1981 the National Commission on Social Security Reform (sometimes referred to as the Greenspan Commission after its chairman) was appointed by Congress and President Reagan to work on the financing crisis in Social Security. The result of their study included several amendments that were passed by Congress, signed by President Reagan and made into law in 1983.
As originally passed, if the taxpayer’s combined income (total of adjusted gross income, interest on tax-exempt bonds, and 50% of Social Security benefits and Tier I Railroad Retirement Benefits) exceeds a threshold (base) amount ($25,000 for an individual with a filing status of single or head-of-household, $32,000 for a married couple filing a joint return, $0 if married filing separately and the taxpayer lived with his or her spouse at any time during the tax year), the amount of benefits subject to income tax is the lesser of 50% of benefits or 50% of the excess of the taxpayer’s combined income over the threshold (base) amount. The additional income tax revenues resulting from this provision are transferred to the trust funds from which the corresponding benefits were paid.
The 1993 formula amendment increased the maximum due to no more than 85% of benefits (and added a second tier adjusted base amount of $44,000 for married taxpayers filing jointly, $0 for married taxpayers filing separately and not living apart during the entire tax year and $34,000 for all other taxpayers). From 1983 until the present, the cumulative rate of inflation has been 137.5% and, yet, the threshold (base) amounts have never been increased.
As an example, in 2014, a married couple (both 63 years old), filing jointly, one retired and drawing benefits and the other still working full-time (and not drawing benefits) have the following sources of income: wages at $40,000; interest income of $1,500; taxable pension retiree income of $14,000; and Social Security benefits of $18,000. In this scenario, the couple would be required to report 85% of the Social Security benefits (or $15,300) as taxable benefits on their return! The couple’s taxable income, after the standard deduction ($12,400) and two personal exemptions ($7,900) would be $50,500. Their marginal (highest) tax rate would be 15%. Fifteen percent times the taxable Social Security benefits will add an additional $2,295 to their tax bill.
Although you can ask for federal income tax withholding on your Social Security benefits, most first-timers who owe tax are caught with their pants down and end up with a tax bill (or significantly reduced refund). Also, if you do owe a balance on your federal tax return greater than $1,000, you could be subject to an underpayment penalty!
Thirteen states also tax Social Security income. Some states mirror the way Social Security is taxed on the federal level, while others have their own set of rules that they go by. For those that mirror the federal formula, repealing the tax at the federal level would also eliminate the state tax burden on this income.
One final kick in the pants: In 2015, if you continue to work for wages or have self-employment income and you are drawing Social Security retirement benefits before full retirement age (66), you will be required to pay back to Social Security one dollar for every two dollars you earn in excess of $15,720. Different rules apply for the year you reach full retirement age. Early retirees who continue working may have taxable Social Security benefits (more likely if they are filing a joint return and the other spouse is also working) and yet still be required to pay back some of those benefits for the same year if earnings exceed the Social Security exempt amount.
It’s past time for Congress to repeal the taxation of Social Security benefits. Unlike an IRA or 401k retirement plan, which allows a participant to reduce the current year’s taxable income by the amount of his or her annual contributions, employees received no income tax deduction for mandatory Federal Insurance Contributions Act (FICA) deductions withheld from their paychecks during their working lifetime. Surely this tax provision can be repealed and offset by reducing the billions of dollars of fraud and waste in the federal budget. The federal earned income credit (EIC) program alone has fostered billions of dollars in fraudulent claims that have been paid out and never recovered. In 2013, the IRS estimates it paid out $5.8 billion in fraudulent refunds to identity thieves.
RECOMMENDATIONS (in order of preference):
1. Repeal the taxation of Social Security benefits.
2. Index the income threshold (base) amount to the rate of inflation before Social Security benefits can be taxed. The cumulative rate of inflation since 1983 (when the law was originally passed) to 2015 is 137.5%. That would move the threshold (base) amount immediately for married couples to $76,000 (from the original $32,000) and for singles to $59,000 (from the original $25,000). This would help a substantial segment of our middle-class income seniors have a better quality of life, which they have earned.