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The Taxation of Social Security Benefits Has Created Quite the Dilemma

Sean Williams, The Motley Fool

According to the Social Security Administration (SSA), almost 62 million people, most of them retired workers, received a benefits check in November. For a majority of these retirees, their Social Security income isn't just some extra cash to count at the end of the month. It's actually an indispensable source of income that they couldn't do without. SSA data shows that 62% of these retired workers nets at least half their income, if not more, from Social Security.

Yet, America's most important social program isn't in the best shape. The latest report from the Social Security Board of Trustees in 2017 forecast that the Trust will begin paying out more in benefits than it generates in revenue by 2022. Just 12 years after that, Social Security's asset reserves are expected to be depleted. If and when this happens, an across-the-board cut in benefits of up to 23% may be needed to extend payouts through the year 2091. 

A Social Security card next to an IRS tax form, a pair of glasses, and a twenty dollar bill.

Image source: Getty Images.

In addition to demographic changes -- which includes the ongoing retirement of baby boomers and increased longevity -- wreaking havoc on Social Security, beneficiaries are also dealing with a fairly consistent loss in purchasing power with regard to their benefits, as well as the potential reduction of take-home benefits via federal taxation. This latter point is a source of great debate, and it's created quite the conundrum for the program.

Why are Social Security benefits being taxed?

The taxation of Social Security benefits was first introduced in the Social Security Amendments of 1983. This tax was part of a broader package designed to raise revenue and cut long-term costs for the Social Security program. As the Amendment summarizes:

Beginning in 1984, includes up to one-half of Social Security benefits as taxable income for taxpayers whose adjusted gross income, combined with half their benefits and any tax-exempt interest they may have exceeds $25,000 for a single taxpayer and $32,000 for married taxpayers filing jointly. 

In plainer English, earning above these thresholds allowed the federal government to expose up to half of a beneficiary's Social Security benefits to ordinary income tax. The move was expected to affect around one in 10 beneficiary households.

Then, in 1993, the Clinton administration added a second tier, allowing up to 85% of a beneficiary's Social Security income to be exposed to federal income tax. In order for this tier to apply, single taxpayers would have to have an adjusted gross income above $34,000, with couples filing jointly above $44,000.

An IRS agent examining tax returns at his desk.

Image source: Getty Images.

Here's the dilemma caused by the taxation of Social Security benefits

Now that you understand why there's a tax, and who is taxed, let's get into the nitty-gritty of why the taxation of benefits has created such a dilemma.

On one hand, eliminating the taxation of benefits makes sense. After all, retired beneficiaries who earn more than the income thresholds are essentially having to hand money back to Uncle Sam that was, in their minds, already taxed while they were working. If this tax were eliminated, middle-income retired workers would see an immediate boost in their monthly pay, putting these folks on a more firm financial foundation.

To boot, the income thresholds associated with the taxation of benefits haven't been adjusted for inflation once in the past 35 years. According to The Senior Citizens League, a tax that had once affected around 10% of households now impacts 56%, with this figure expected to move higher as time passes. It's evident that this tax is hitting households that it was never intended to impact, which is a pretty good reason to can this tax. 

Then again, there are two superseding issues.

Dice and casino chips lying atop Social Security cards.

Image source: Getty Images.

First, there's that not-so-tiny problem known as Social Security's $12.5 trillion budget shortfall between 2034 and 2091. If the taxation of benefits were removed, around 3% of Social Security's annual revenue would disappear. In 2016, the taxation of benefits was responsible for $32.8 billion (3.4%) of collected revenue. Without this channel of revenue, Social Security's asset reserves would likely deplete even faster.

Second, the GOP tax law that President Trump recently signed is expected to increase the federal deficit by $1.5 trillion over the next decade, according to the Joint Committee on Taxation. The federal government needs as much tax revenue as it can get, which means not only ensuring that the taxation of benefits remains on the table, but also (possibly) leaving this 35-year-old threshold in place without adjusting for inflation. 

Higher income now for middle-income seniors, the elimination of an archaic tax, or the quicker depletion of the program's asset reserves, assuming Congress makes no changes to how the program generates income. That's the conundrum.

Your move, Congress.

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