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Income From the Taxation of Social Security Benefits Will More Than Double by 2026

Sean Williams, The Motley Fool

Even though Social Security is arguably the most important social program in this country, it doesn't mean it's impervious to problems. According to the newest Social Security Board of Trustees report released in early June, Social Security is undergoing major changes right now that could soon adversely impact the payouts of current and future eligible beneficiaries.

Based on the intermediate-cost model of the report, Social Security is projected to begin paying out more in benefits this year than it collects in revenue. This would mark its first net cash outflow since 1982, the year prior to the passage of the last major overhaul of the program by the Reagan administration. Although the $1.7 billion net cash outflow looks like peanuts relative to the $2.9 trillion the program has saved up over the past 35 years, this outflow is forecast to accelerate with each passing year after 2019. By 2034, Social Security's asset reserves are expected to be completely gone.

A $100 bill and $20 bill partially covering a Social Security card.
A $100 bill and $20 bill partially covering a Social Security card.

Image source: Getty Images.

Despite Social Security's problems, it's not going to disappear

Pardon the apropos pun, but the silver lining here for seniors who lean on Social Security pretty heavily is that the program isn't in any danger of disappearing. Even if one of its sources of funding -- the interest income earned on its spare cash via special-issue bond purchases -- were to disappear, its other two funding mechanisms would continue to collect revenue that could be dispersed to eligible recipients.

Mind you, this doesn't mean the current payout schedule is sustainable. The Trustees have opined that a benefits cut of up to 21% may prove necessary if lawmakers are unsuccessful in raising additional revenue and/or reducing long-term expenditures. But the program itself is incapable of insolvency as it's currently set up.

Of the remaining two sources of funding, the 12.4% payroll tax on earned income of up to $128,400 (as of 2018) does most of the heavy lifting. Last year, the payroll tax provided $873.6 billion of the $996.6 billion collected by the program. Over the next decade, as the labor force and cumulative wages grow, more money should be collected via the payroll tax. Or put in a much simpler context, as long as the American public keeps working, the payroll tax will do its job by collecting revenue to keep Social Security afloat.

A Social Security card wedged in between tax paperwork.
A Social Security card wedged in between tax paperwork.

Image source: Getty Images.

The taxation of benefits is taking on an increasingly important role

But don't count out the role that the taxation of benefits will play going forward -- or as I like to call it, Social Security's "necessary evil."

The taxation of Social Security benefits was introduced with the passage of the amendments of 1983. It was initially designed to tax well-to-do households receiving benefits, thereby boosting long-term revenue for the program. Single taxpayers whose adjusted gross income (AGI) along with half of their Social Security benefits exceeded $25,000 could have half of their benefits taxed at ordinary federal income tax rates. For couples filing jointly, this figure was set at $34,000.

Then, under the Clinton administration in 1993, a second tier of taxation was added. Factoring in AGI plus one-half of Social Security benefits paid, a single taxpayer netting in excess of $34,000 could have 85% of his or her benefits exposed to federal income tax, with the same being true for couples filing jointly with earned income of over $44,000.

The catch is this: The income thresholds tied to the taxation of benefits haven't been adjusted for inflation since they were introduced (so 25 years ago for the 85% tier and 35 years ago for the 50% tier). Thus, a tax that once impacted around 10% of senior households now affects 56%, according to an analysis from The Senior Citizens League. Basically, your chances of paying federal tax on your Social Security benefits during retirement are, in theory, rising with each passing year -- and it certainly shows in the Trustees' forecast.

Looking at the short-term forecast (10 year) for the intermediate-cost model, the taxation of Social Security benefits is expected to bring in $34.6 billion in 2018. But by 2026, eight years later, it's expected to generate $81.5 billion for the program. This more than doubling in revenue is the result of the sunset of individual tax cuts passed along with the Tax Cuts and Jobs Act on Dec. 31, 2025, as well as more and more beneficiaries being exposed to the taxation of benefits each year because the income thresholds aren't being adjusted.

An angry senior man with a stern look on his face.
An angry senior man with a stern look on his face.

Image source: Getty Images.

The taxation of Social Security benefits isn't going anywhere

Not surprisingly, seniors strongly dislike the taxation of benefits, and a majority wish it would go away. A 2017 survey from The Seniors Center, a Washington, D.C.-based nonprofit organization, revealed that 91% of retired Americans felt that Social Security benefits shouldn't be subject to federal taxation. Unfortunately, even if this figure was 100%, Congress has virtually no incentive to remove the taxation of benefits or even to adjust the income thresholds for inflation.

As noted, the program is 16 years away from burning through $2.9 trillion in excess cash. If the taxation of benefits were removed, then Social Security would lose out on an estimated $561.2 billion in revenue over the next decade. That would only further balloon the deficit that Social Security is facing over the next 75 years, and it would likely deplete the program's asset reserves even faster.

As much as seniors loathe the taxation of benefits, there's little doubt in my mind that it's not going anywhere anytime soon.

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