Is it Time to Change Social Security Taxation?

If Congress gets serious about tax reform, taxes on Social Security income could be on the table.

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The U.S. tax system needs to be overhauled, critics say, particularly the provisions that allow taxpayers to avoid forking over more than $1 trillion each year due to what are known as "tax preference" items in the law. Populist rhetoric argues that people are good and corporations are greedy, so tax reform is often viewed as something the public should support.

In reality, however, some of the biggest tax preference items flow to consumers, including the tax-deductibility of mortgage interest payments and the ability to use pre-tax income to pay for employer health insurance. The benefits are directly related to income levels, so these preference items are particularly helpful to higher-income taxpayers.

But if proponents of tax reform are serious about their work, they should look at tax preference items geared toward lower-income and middle-income taxpayers. One of these items is the set of rules that govern federal taxation of Social Security benefits.

As anyone who has wrestled with Social Security benefits knows, some program rules are very complicated. Social Security benefits are exempt from taxation until a taxpayer's income reaches a certain level, including Social Security and all other taxable wages, investment earnings and other income. (The figure used by the IRS is called "modified adjusted gross income.") For people filing individual tax returns, this threshold is $25,000 a year. For joint tax returns, it's $32,000 a year.

Between total annual incomes of $25,000 and $34,000 ($32,000 and $44,000 for joint filers), Social Security benefits become taxable at the rate of 50 cents of every benefit dollar for each dollar of extra income over the threshold. There is a second tier as well, because above these amounts, 85 cents of each Social Security benefit dollar is subject to tax for each dollar of extra income above $34,000 ($44,000 for joint filers).

The purpose of the sliding tax scale, of course, is to exclude Social Security benefits from taxation for lower-income beneficiaries. "If Social Security benefits were your only income, "your benefits are not taxable and you probably do not need to file a federal income tax return," the IRS states on its website.

That may be good social policy, but Michael Schuyler, author of a case study on this topic by the non-partisan Tax Foundation, notes that the rules inflict a nasty tax hit on people of moderate means who hit the income cut-off points built into the law.

At income levels that subject 50 percent of Social Security benefits to taxation, according to the study released this month, the person's taxable income actually rises by $1.50 – the $1 of extra outside income that triggered the inclusion of Social Security benefits as taxable income in the first place, and the 50 cents of the benefit dollar that is now included in taxable income.

A person in the 15 percent tax bracket thus experiences an effective tax rate of 22.5 percent, the study said. And the hit is worse for the income tier at which 85 cents of each benefit dollar is subject to taxation. "In the second tier, the effective tax rate is 185 percent of the statutory rate," the study said. "A taxpayer in the 25 percent bracket faces an effective tax rate of 46.25 percent on other income while his or her benefits are being phased into taxable income."

"The current law method of partially bringing Social Security benefits into the income tax base is widely acknowledged to be complicated," Schuyler told U.S. News in an email. "What our Tax Foundation study found is that it also damages economic growth."

"The current-law income tax treatment of Social Security benefits sends a strong signal to seniors who are within the phase-in range to hold down savings and work hours," he explained. If this provision was eliminated, Treasury revenues would increase twice – once by eliminating the tax preference entirely and a second time by stimulating seniors to work more and thus further boost their taxable incomes.

Alternatively, the direct savings to the Treasury could be returned to beneficiaries by adjusting the law to soften or remove the big work disincentive it now contains, Schuyler said. The economic benefits of not discouraging seniors to continue working would still take effect, and the government would come out ahead anyway.

"Suppose the objective is not to find new revenue to finance [income tax] rate cuts but to develop a simpler, less growth-damaging way to impose the income tax on Social Security benefits," he explained. "An attractive approach would be to scrap the current treatment, exempt a certain amount or percentage of Social Security benefits from income taxation and treat Social Security benefits above the exemption as ordinary income. The exemption would be adjusted so it is revenue-neutral compared to current law."

If any of this sounds either like good policy or a threat to current tax benefits, people shouldn't expect anything to happen soon. "Although I'm always cautious when trying to predict what Congress will do, my guess is that the income tax treatment of Social Security benefits will not change in the near future," Schuyler said.

Twitter: @PhilMoeller