Recent discussions, as well as remarks made by President Donald Trump on the campaign trail, have included the proposal to eliminate the federal income taxation of Social Security benefits. That would be costly to the federal budget and the Social Security and Medicare Trust Funds, accelerating their expected exhaustion dates, and it would favor higher-income retirees and workers.
Instead, lawmakers should discuss taxing Social Security benefits the same as contributory pension plan benefits. That would slightly decrease the percentage of Social Security benefits that are taxable, particularly for those who retire at earlier ages and have higher incomes.
The 1983 legislation that saved Social Security from imminent bankruptcy first introduced the federal taxation of Social Security benefits. Tax proceeds from this first tier go to the Social Security Trust Fund. Budget legislation in 1993 added a second tier of taxation, going to the Medicare Trust Fund. Beneficiaries with combined income, adjusted gross income plus nontaxable interest income and half of Social Security benefits, above $25,000, or $32,000 for joint filers, pay taxes on 50% of their Social Security benefits in the first tier. Those with combined income above $34,000, or $44,000 for joint filers, pay taxes on the next 35% of Social Security benefits in the second tier. These income limits are not indexed — recent high inflation has thrown more retired households unexpectedly into the first and second tiers of taxation. The main purpose of these tax provisions is to increase the flow of money to the trust funds, but with the exception of the income limits, they are broadly consistent with the good policy that all retirement income should be taxed.
According to calculations by the Penn Wharton Budget Model, eliminating income taxes on Social Security benefits would reduce revenues by $1.5 trillion over the next 10 years and increase the federal debt by 7% by 2054. The proposal also would move the projected exhaustion of the Social Security Trust Fund forward by two years, from 2035 to 2033. The largest tax reductions would go to the top income quintile, with annual gains of about $2,000 in 2026, and the largest relative gains would go to the fourth income quintile, at more than 1% of income.
Under current tax law, pension benefits funded by pretax contributions, whether from the employer or the employee, are fully taxable. If some contributions were made from after-tax income, however, then the recipient can exclude the total of those contributions, or “the cost,” from taxable benefits. The tax-free part of each annuity payment is calculated by dividing that accumulated amount by the total number of anticipated monthly payments from the pension, using an IRS table according to the age when benefits begin. This table essentially contains simplified life expectancies. The tax-free portion is fixed at the time of initial payment even if subsequent payments increase, but if the beneficiary does not recover his cost basis before death, any unrecovered amount is allowed as an itemized deduction on the final return of the decedent.
Applied to Social Security benefits, these rules would mean that at the time of claiming retirement or disability benefits, the individual would be provided with the total contributions he, not his employers, made over his working lifetime because these contributions came from taxable earnings. He would have to pay taxes on the portion funded by his employers and any excess of benefits greater than his cost share. The tax-free share would be determined by the simplified IRS life expectancy table. See some examples below of the taxation of Social Security benefits of retired employees under pension tax rules for various retirement ages and earnings levels.
| Taxable Portion of Social Security Benefits Under Pension Tax Rule (%) | |||
| Annual Earnings in Year of Retirement | |||
| Retirement Age | $30,000 | $60,000 | $120,000 |
| 62 | 86.9 | 81.6 | 77.0 |
| 65 | 88.8 | 84.4 | 80.7 |
| 70 | 90.7 | 87.1 | 84.4 |
| Note: Earnings history and benefit calculation based on SSA “Quick Calculator.” Assumed 6.2% employee and employer payroll tax rates for Social Security | |||
As shown, the taxable portion of benefits under pension rules is lowered for most early retirees and higher-income individuals, mainly because the relative generosity of Social Security is less for them — meaning that they pay more for similar value of benefits. Another advantage of pension rules is that the taxation adjusts automatically with changes in Social Security. For example, if scheduled benefit levels are lowered in a reformed and sustainable system, the taxable share would be reduced.
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Congress should not repeat its recent mistake in passing the Social Security Fairness Act, which unfairly increased benefits to high-income government retirees and workers, worsened the budget deficit, and reduced the trust fund. Rather, it should reform the current taxation of Social Security benefits to make it consistent with the logical tax rules applying to contributory pensions.
The progressivity intended by the current benefit exclusion from taxable income for low-income households is accomplished better by increasing the indexed standard deduction for elderly and disabled people.
Mark Warshawsky is a senior fellow at the American Enterprise Institute. He was a deputy commissioner for retirement and disability policy at the Social Security Administration.
