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Retirement Focus - Double Taxing Social Security Benefits

By Gary D. Halbert
June 5, 2007

By Mike Posey


1.   Some Background Information

2.   Why The System Is Broken

3.   A Personal Illustration

4.   Why Doesn’t Congress Just Fix This Problem?

5.   What You Can Do

Editor’s Note:  Being a self-described “political junkie,” I am very familiar with the “law of unintended consequences,” especially as it relates to Congress.  In this week’s Retirement Focus edition, Mike Posey describes a tax that was originally designed to apply only to upper income retirees, but will likely end up hitting millions of middle-class Americans when they start receiving Social Security benefits.  Most people who are not yet retired don’t even know about this, so read the article below carefully.  Take it away Mike.


First, let me thank all of you who sent ideas for future retirement planning articles as I requested in the May 1 Retirement Focus issue.  The vast majority of the suggestions centered around managing post-retirement income and withdrawal rates.  Many commented about how most of what they see about retirement planning is geared toward getting to retirement, but not what to do afterward.

I’m glad to know that post-retirement issues are important to you, as I had already planned a series of articles dealing with the many decisions necessary at and following retirement.  In fact, I had actually planned to start with my first post-retirement installment this week, but I got sidetracked by another topic that will affect many of us after we retire. 

Anyone who has researched the long-term effects of legislation on our lives knows about the “law of unintended consequences.”  As it applies to Congress, it’s the idea that laws passed to address specific wants or needs sometimes have long-term effects that are unanticipated at the time of enactment. 

One such law that has recently been in the news is the Alternative Minimum Tax (AMT).  This tax was passed in 1969 to prevent high-income households from using loopholes to completely escape income taxation.  However, though originally targeting only “fat cats,” the law is now affecting a growing number of middle class taxpayers, especially married households where both spouses are employed. 

The problem with the AMT is not necessarily that certain tax deductions and exclusions should be phased out for those with high incomes, but rather that the income thresholds in the original law have never been updated.  After all, what was considered a very high income in 1969 may be the same as what a two-earner household is just barely squeaking by on today.  Had the AMT income thresholds been indexed to inflation, middle class taxpayers would likely not be affected.

Today’s E-Letter isn’t about the AMT.  Instead, I’m going to tell you about how the same law of unintended consequences may also affect your retirement income, if allowed to continue as-is.  Specifically, the law providing for taxing a portion of Social Security benefits was passed in 1983, but like the AMT, was not indexed to inflation.  Thus, as Baby Boomers reach retirement, more and more retired taxpayers will find their tax bills are going to be higher than anticipated, possibly even resulting in double taxation.  

Some Background Information

Gary has previously written about how the 1983 Greenspan Commission recommended raising Social Security tax rates and creating a “trust fund” to hold all of these excess contributions.  Less well-known is the Commission’s recommendation to tax a portion of the Social Security benefits received by high-income taxpayers.

Under the 1983 law, 50% of Social Security benefits would be taxable for single retirees earning $25,000 of “modified” income (a special income calculation that adds back tax-exempt interest and one-half of Social Security benefits), or $32,000 for married couples filing jointly.  At the time, the $25,000 and $32,000 income thresholds were not much of an issue.  The problem is that these thresholds were not set up so that they would keep up with inflation over time.

The rationale behind this tax was that only about 10% of all recipients would be affected based on the income thresholds at the time, but estimates are that it now affects 22% of retirees, and this number will only increase with time.

And here’s the real kicker: The Commission recommended that the proceeds of this taxation be added to the Social Security “trust fund” rather than being used for the general budget.  What a laugh!  We all know that the “trust fund” is invested in a class of Treasury Bonds that are little more than an accounting entry, so Congress has been busy spending this money just like they have the excess Social Security taxes. 

On that subject of the “trust funds,” Gary put it best in his February 13, 2007 E-Letter when he discussed Fed Chairman Ben Bernanke’s comments on the future of Social Security.  Gary said:

“A 2002 Congressional Budget Office Policy Brief probably best described this arrangement:

‘Trust fund holdings, as internal liabilities between government accounts, are not assets of the government. Nor do they represent money owed to program recipients individually; payments to Social Security recipients and beneficiaries of other social insurance programs are based on a variety of rules set by law unrelated to trust fund holdings. A federal trust fund is basically an accounting device that measures the difference between the income designated for a specific program and the expenditures made to its beneficiaries. The accumulated difference, or balance, often represents a reserve of future "spending authority" for the program, but it is not a reserve of money for making payments.’ [Emphasis added]

‘In the future, when receipts for such programs as Social Security fall below their expenditures, the legal authority to pay benefits will exist as long as their trust funds have balances, but the government will have to generate cash to pay benefits either by running a surplus in the rest of the budget--which would probably require cutting other spending or raising taxes--or by borrowing from the public.’

Note the last part of the CBO’s statement.  If we’re not running budget surpluses by the time entitlement expenditures are expected to overtake tax revenues (fat chance!), then the government will have to borrow from the public.  That means fund the “spending authority” with Treasury Bonds.  To me, that sounds a little like paying your VISA bill with your MasterCard.”

And if the 1983 law wasn’t bad enough, a 1993 update under the Clinton Administration increased the amount of Social Security benefits subject to taxation and added another layer of income thresholds.  Under the 1993 revision, a married couple filing jointly with modified income (again including tax-exempt interest and one-half of Social Security benefits) of $44,000 per year ($34,000 for singles) would have up to 85% of their Social Security benefits subject to income taxation.  (In the remainder of this article, I will just refer to the $32,000 and $44,000 figures for couples.)

Once again, Congress did not take any steps in 1993 to modify the original income thresholds (then 10 years old) or index them to inflation for the future.  As a result, the current, 2007 law of the land dictates that retirees will pay taxes on some portion of their Social Security benefits if their post-retirement income exceeds levels set over 23 years ago.

Unfortunately, the tax calculations are too complex to get into in this short E-Letter.  However, I can provide some very basic guidelines based on my best understanding of the tax rules:

1. If you earn under the applicable thresholds, you will not owe any tax on your Social Security benefits;

2. If your modified income is over $32,000 but less than $44,000, you will owe tax on up to 50% of your Social Security benefits; or

3. If your modified income is over $44,000, then you must include up to 85% of your Social Security benefits in taxable income, based on the extent to which your modified income exceeds the threshold amount.

Of course, the above information should not be considered tax advice, so you need to contact a tax professional if you are currently retired and receiving Social Security benefits.  Plus, the income levels given above are for couples filing jointly.  Single individuals will have lower threshold amounts.  Lastly, while most states with an income tax exempt Social Security benefits, it is important to note that there are a dozen or so states that do tax at least some portion of Social Security benefits under certain conditions.  Again, check with a local tax professional to see how your state treats Social Security benefits.

The bottom line is that, just as with the AMT, an ever-increasing number of retirees will be affected by these obsolete income thresholds.  As the Baby Boomers retire, average monthly benefits will increase, as may employer retirement benefits and/or post-retirement income.  The result will be many more retirees having their Social Security benefits subject to taxation than was ever intended by Congress in 1983, or so we are led to believe.

By the way, here’s a little trivia for you.  The Omnibus Budget Reconciliation Act of 1993 (“OBRA”) is the legislation that provided for up to 85% of Social Security benefits to be taxed.  When the bill came up for a vote, the Senate ended up in a tie.  Do you know who cast the tie-breaking vote in favor of the bill to increase the tax on Social Security beneficiaries?  That’s right, our friend Al Gore.

Why The System Is Broken

Some of you may be thinking that I’m over-reacting to this issue.  After all, employees currently pay only half of the Social Security tax, and the employer pays the other half.  Thus, it may only seem right that this employer contribution be taxed.  While Social Security benefits were totally untaxed prior to 1984, the Greenspan Commission used the 50/50 contribution split as its rationale for subjecting half of benefits to taxation under certain conditions.

My biggest problem comes in when we start pushing the percentage subject to taxation up to 85%, but not indexing the income thresholds to inflation.  Indexing for inflation simply means that the income threshold (originally $32,000 in 1983) would be increased by some pre-determined measure of inflation each year.  Without such indexing, many Baby Boomers may pay taxes on the receipt of some of their own after-tax Social Security contributions.

The bogus nature of the 85% taxation rate really comes out when you review some of the history behind its enactment.  It seems that experts at the time said that the average 1993 Social Security recipient had employee contributions equal to only about 15% of the total monthly benefit received.  Actually, I don’t argue that point, since the numbers were based on a snapshot in time with people who had retired prior to 1993, meaning they were born in 1927 or earlier.

Social Security tax rates were much lower during most of these individuals’ working lifetimes, so their contributions likely only accounted for 15% of the total benefits received.  However, beginning in 1984, Social Security tax rates were gradually raised as suggested by the Greenspan Commission, so that they stand at 6.2% today for the combined Old Age and Survivors Insurance and Disability Insurance (“OASDI”) portions, and 1.45% for Medicare coverage. 

In addition, the amount of compensation subject to Social Security Tax, known as the Taxable Wage Base, has also been increasing.  In 1983, when the Greenspan Commission recommen-dations were written into law, the amount of annual compensation subject to the OASDI was $37,900.  In 2007, that figure is $97,500.  As a result of the higher tax rate and wage base, those retiring in the future will likely have a much larger paid-in amount than those who retired in 1993, especially if they have a history of good earnings.

I find it interesting that the Taxable Wage Base and Social Security benefits themselves have been adjusted for inflation for many years.  The idea of indexing the income thresholds for inflation would not have been anything new in 1983 or 1993, so one could argue that indexing the income thresholds for inflation was intentionally omitted from these laws.

What the defenders of this tax failed to realize (or admit) is that the effects of the ever-increasing Taxable Wage Base, coupled with the Greenspan Commission’s higher tax rates, would eventually push retirees into income levels that would subject part of their Social Security benefit to income taxes.  If it is appropriate to index the Taxable Wage Base and benefits themselves to inflation, then it is appropriate to index these income tax thresholds.

To illustrate what indexing might have done, I used an online inflation calculator.  The $32,000 income threshold set in 1983 would have been $64,447 in 2006, had it been adjusted for inflation.  Even more interesting is that had the original $32,000 threshold been adjusted for inflation, by the time Congress passed its revisions in 1993, it would have increased to $46,490.

That’s right, the original $32,000 would have already been greater than the “higher” $44,000 threshold established in the 1993 legislation, had it been indexed to inflation.  Saying it another way, Congress required taxing up to 85% of Social Security benefits based on an income level that was actually lower, on an inflation-adjusted basis, than the original $32,000 threshold.  Just another example of your tax dollars at work!

A Personal Illustration

Perhaps the best way for me to illustrate the effect of the Social Security tax on Baby Boomers is to use myself as an example.  Back in 1955, my parents welcomed little Michael Posey into the world, placing me smack in the middle of the Baby Boom generation.  As a result, I am a perfect case study for the effects of the Social Security income tax.

Each year, the Social Security Administration sends out a Social Security Statement to each worker or former worker aged 25 or older.  These statements provide information about your estimated retirement benefit at various ages, as well as disability, family and survivor coverage.  They also provide a record of the amount of Social Security tax both employees and their employers have paid over the working lifetime of the individuals.  Thus, there is enough information in this document to estimate what percentage of the projected monthly benefit is made up of employee contributions.

I rustled through my desk here at the office and found my Social Security Statement from 2003.  I have more recent ones at home, but this one will suffice to illustrate my point.  My statement says that my Social Security retirement age is 66 years and two months, at which time I can expect to receive a benefit of $2,064 per month ($24,768 annually).  Notations on the statement explain that this benefit is calculated by assuming my 2003 level of earnings will continue until my eventual full retirement date.

My statement also shows that I had paid $79,265, after tax, into the program through 2003.  Using the 6.2% Social Security OASDI employee tax rate, I calculated my future contributions, added them to my existing total and came up with a grand total of $172,761 of estimated personal after-tax contributions at full retirement.

I then looked up the average life expectancy for a 66 year-old male, and found that the actuaries assume I will live about 16 more years (females get a few extra years, on average).  That means I should collect my $2,064 per month for 192 months, for a total of $396,288.  Doing a little division shows that my total personal Social Security contributions will be about 44% of my total projected benefits, assuming I live only to my life expectancy ($172,761 divided by $396,288 = .436).

That’s almost three times more than Congress’ 15% assumption.  Of course, if I live longer, the numbers get better.  Just how long?  In order for my $172,761 of contributions to equal only 15% of my expected benefit, I’d have to collect benefits for over 46 years after retirement.  Maybe I’ll still be writing these Retirement Focus editions when I’m 112, but I kinda doubt it.

Of course, those of you with an actuarial flair have realized that this illustration does not reflect any projected cost of living adjustments (COLAs), which are an integral part of Social Security.  The average Social Security COLA since 1990 has been in the 3% range.  If I apply this increase to my $24,768 annual benefit beginning at age 66, by the time of my actuarial demise (16 years) I will have received a total estimated benefit of $499,246. 

Assuming the 3% COLA, my personal contributions should equate to about 35% of my total projected benefits, which is less than 44% but still more than double the 15% Congressional assumption.  Using a 3% annual COLA also means that I’ll only have to live to be 95 for my $172,761 of personal contributions to equal a mere 15% of my benefits received.  I feel much better now. 

In the spirit of full disclosure, the above assumes a single Social Security beneficiary, and I am married.  I could continue to muddy the water by factoring in joint life expectancy with my spouse, splitting out the disability insurance premium, etc., etc., but I think you get the picture:  If you have a good earnings history, it’s very possible that you will be paying tax on an after-tax payroll deduction when you retire.   

Just for fun, you might want to find your latest Social Security statement and do some of the same math I did above and see how you may fare.  You can get online calculators to do the 3% benefit increase calculations at the following link.  Use the one that says “Future Value of an Ordinary Annuity.”

Why Doesn’t Congress Just Fix This Problem?

By now, I hope that you have realized that the law that requires taxation of up to 85% of your future Social Security benefit is broken.  So, why doesn’t Congress fix it?  While there have been bills introduced to do just that, they have never passed.  I assume the reason for this is because, like the Alternative Minimum Tax issue, taxation of Social Security benefits produces revenue.

I really prefer to leave the political commentary to Gary (see his comments below), but it really doesn’t matter whether the failure to index the income thresholds to inflation was intentional or an oversight – it produces tax revenues.  Politicians of both parties love tax revenues, especially those that are on “automatic mode” to gradually increase over time. 

Plus, now that Congress has reinstated the “pay as you go” rule, any attempt to right this wrong will have to be accompanied by an equal amount of spending cuts.  As Baby Boomers begin to retire and the tax revenue from this provision continues to increase, it will just get harder and harder for Congress to take any action to correct it. 

This will be especially true in regard to this tax, since the revenues are earmarked for the Social Security and Medicare “trust funds.”  As we come closer to 2017, the year that the Social Security trustees estimate benefit payments will exceed tax receipts, protection of the “trust funds” will likely become even more of a sacred cow in Washington. 

What You Can Do (For Now)

Whenever I write about a problem or potential problem, I always try to provide a possible solution.  The case of taxable Social Security benefits is a tough one, in that the better you and your employer do for you to have a secure retirement, the greater the chance that you will be hit with having up to 85 cents of every benefit dollar subject to taxation.

There is one possible solution, at least for now.  Absent future Congressional action, you may be able to meet your retirement needs and not run afoul of Social Security taxation if you do so within a Roth IRA or Roth 401(k) account. 

For those of you who may not be familiar with these programs, a Roth IRA or 401(k) provide for tax-free accumulation of earnings, but without any tax deduction for the original contributions.  Contributions must be held for five years to attain tax-free status, and there is even a way to convert a traditional IRA to a Roth IRA, under certain conditions.  Roth IRAs are available for individuals, while employers with 401(k) plans can elect to include a Roth 401(k) provision.

The Roth’s tax-free withdrawals may make it attractive for those who want to minimize the amount of their Social Security benefit subject to taxation.  When making modified income calculations, current law requires taxpayers to add back tax-free interest, such as that available from municipal bonds.  There is currently no similar provision that I can find for distributions from Roth IRAs or 401(k)s, based on the IRS worksheets I reviewed.

Roth accounts can also be an advantage in regard to deciding when to take withdrawals.  Under current law, traditional IRAs must begin making mandatory minimum distributions when the account holder reaches age 70½.  There is no such provision for Roth IRAs, so income planning can be much more flexible.

However, the decision to designate a Roth IRA or 401(k) account should not be made lightly.  While a Roth account may be a way to escape taxation on Social Security benefits, it is important to note that not everyone is eligible for a Roth IRA, and not all employers with 401(k) plans permit Roth 401(k) contributions.  In addition, Roth accounts are not suitable for everyone, since they generally favor those who are young and have many years to accumulate tax-free earnings.

The entire subject of whether to invest in a Roth or traditional IRA or 401(k) account will be the subject of a future Retirement Focus E-Letter.  Therefore, don’t run out to establish a Roth account just because it may save you some tax money later on.  If, however, your personal financial situation makes a Roth IRA of Roth 401(k) attractive, then the Social Security taxation advantages may be an added benefit.

The reason for my caution in recommending Roth accounts is because Congress can change the rules in regard to Roth IRA and 401(k) distributions at any time.  While Roth accounts currently appear to be exempted from the modified income calculation, it may not always be so.  Congress has a nasty habit of coming back to fix perceived loopholes, sometimes years after the original legislation was enacted.  If Roth IRA and 401(k) accounts continue to gain popularity, politicians may do just that.

By Gary Halbert

Since this week’s Retirement Focus issue turned toward the political, I just couldn’t resist adding my own two-cents worth.  As you can probably tell, Mike and I tend to see things eye-to-eye, politically speaking.  His analysis of the failure to include inflation adjustments in the law that provides for the taxation of Social Security benefits is right-on, in my opinion.

However, I would like to take the political discussion a step (or two) further.  I think a recent article in our local newspaper on this very same topic put this matter in the most appropriate political context.  In the article, financial columnist Scott Burns featured what he called his “Rude Opinion Poll:”

“Which description best characterizes our elected representatives in Washington, regardless of party affiliation?

1. They are hapless boobs, constantly passing laws that contradict each other; or
2. They are scheming miscreants, relentlessly seeking new ways to increase taxes and spend more of your money.”

To Burns, having only two alternatives is sufficient when you consider the future effects of the law taxing a portion of Social Security benefits.  They were either asleep at the wheel, or they knew what they were doing all along.  Any way you look at it, the 78 million Baby Boomers set to retire over the next few decades will pay the price.

I remember that one part of the Republicans’ 1994 “Contract With America” was to repeal this tax on retirement benefits, but you notice that it didn’t happen.  Considering that the original legislation provided for the tax revenues to go to the Social Security and Medicare trust funds, perhaps repeal would have been unpopular in light of warnings, even back then, of impending funding shortfalls in these programs.

What has kept the politicians of both parties from updating the thresholds and then indexing them to inflation?  Perhaps we’ll never know the answer to that question, but many of us will have to live with the consequences.

Face it, inflation adjustments were not new in 1983 when Congress passed the initial law taxing a portion of Social Security benefits, nor in 1993 when it was revised to tax an even greater portion.  In fact, the 1993 law should have increased the base thresholds since the original law had been in effect for 10 years, but they didn’t.  I’m sure it was probably proposed, but the politicians didn’t want to kill what amounted to an automatic annual tax increase.

I did a little research, and I found that there have been numerous unsuccessful attempts to modify or repeal the tax on Social Security benefits, all to no avail.  With an ever-growing chorus of voices warning of a Social Security and Medicare funding crisis, don’t look for it to happen any time soon.

The bottom line is that I think inflation adjustments have been intentionally left out of some tax bills in order to create an ever-increasing stream of tax revenue.  And in response to Scott Burns’ poll, I personally think we have a generous bipartisan helping of Congressmen that fit each of the two descriptions above.

Best regards,


Gary D. Halbert


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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