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On Thursday, the Social Security Administration (SSA) announced the cost-of-living adjustment (COLA) for Social Security payments based on inflation over the previous year. This has brought renewed attention to how the tax code treats Social Security benefits, which can be a confusing subject for taxpayers.
Each year, SSA adjusts Social Security benefits for inflation, much like how certain aspects of the tax code are indexed for inflation. In 2022, for example, Social Security recipients received a 5.9 percent adjustment. For 2023, the cost-of-living adjustment is expected to rise to about 8.7 percent, driven by unusually high inflation that reduces the nominal value of existing Social Security benefits.
The tax treatment of Social Security benefits is complicated and can trip up taxpayers and tax experts alike. That’s because the tax code treats Social Security benefits differently from other types of income. First, taxpayers calculate their “combined income,” defined as their adjusted gross income (AGI), tax-exempt interest income, and half of their Social Security benefits.
Taxpayers who earn less than $25,000 (single filers) or $32,000 (joint filers) in combined income pay no tax on their benefits. Households earning between those thresholds and up to $34,000 (single filers) or $44,000 (joint filers) pay tax on up to 50 percent of their benefits. Above those levels, up to 85 percent of benefits are taxed.
The combined income thresholds were originally established in 1984 and updated in 1993, but have not been indexed for inflation. This means that a larger portion of Social Security benefits will be taxed over time due to bracket creep, especially true in a time of high inflation.
Some policymakers have proposed exempting Social Security payments from income tax altogether, arguing that this could help provide relief from high inflation. While there is a strong case for indexing the combined income thresholds for inflation much like we have indexed ordinary income tax brackets, it would be a step too far to entirely exempt Social Security income from tax. However, there are ways to improve the tax treatment of benefits.
Under the current tax code, employees cannot deduct their portion of payroll taxes paid from their income tax liability, but employers can deduct their portion of the payroll tax as an ordinary business expense (with exceptions for non-profits or firms incurring losses). One way to think about this is that half of the contribution from the payroll tax is treated like a traditional retirement account, where there is a deduction for saving up front, and half is treated like a Roth account, where tax is paid up front.
This means that a portion of the Social Security benefits should be taxed when received, though there are disagreements about the precise amount that should be subject to tax. The tax treatment of Social Security benefits is also complicated by the fact that beneficiary contributions are not tightly linked to benefits as they are with defined contribution plans such as traditional or Roth 401K accounts.
No matter how we think about them conceptually, Social Security benefits should still be considered income, and it would be proper to include them in the income tax base. Broad exemptions from the income tax would not provide longer-term relief from inflation for beneficiaries and would continue the long-running trend of narrowing the income tax base at the cost of higher tax rates.
However, there are options to simplify and improve the tax treatment of benefits. These include indexing the combined income thresholds for inflation and moving away from a confusing mix of traditional and Roth-style treatment.
Instead, the tax code could treat benefits as a traditional or Roth form of saving by either fully taxing or exempting benefits as they are received and modifying how payroll tax deductions are treated in kind. While this may not solve every challenge associated with taxing defined benefits, it would be a simpler process for taxpayers.