Wednesday, August 15, 2007

Means Testing of Social Security Benefits Already in Effect

Jed Pittman on HelpYourMoney has a post entitled "Thoughts on Social Security" which discusses the possibility of means testing for Social Security benefits, and ends that part of the discussion by quoting Ben Stein who said "Those who have saved will be made to pay for those who haven’t ..... "

It just so happens that a mechanism for means testing Social Security benefits is already in place for taxing those who have saved for retirement while not taxing those who haven't.

The way it works is that a test amount is computed based on adding your taxable income (which includes withdrawals from tax-deferred retirement savings) to 1/2 of your Social Security benefit. If the test amount reaches $25,000 for a single person or $32,000 for a married couple, then each additional dollar of income results in taxation of $0.50 of Social Security benefits. At higher test amounts, an additional dollar of income results in $0.85 of Social Security being taxed for each $1 of other income. Specifically when I say that Social Security is taxed, up to 85% of your benefit can be added to your Adjusted Gross Income (AGI). But if your AGI is less than your exemptions and deductions, then it still won't be taxed. Refer to the worksheet for line 20 of the 1040 tax form for details, although the computations are rather mind numbing -- I set up a spreadsheet to do them so I could see how it worked.

The problem is that the $25,000 and $32,000 exclusion amounts in the test computation are not adjusted for inflation.

Let's consider a single person who has not saved for retirement at all and only has income from Social Security. This person has no pension, no portfolio of stocks -- just Social Security. That person would need to have more than $50,000 in Social Security benefits before 1/2 of it exceeds $25,000 and any of his benefit is added to his AGI. Exemption and standard deduction for a single person adds up to almost $10,000 in 2007 for a single person 65 or older. So this year over $80,000 of Social Security benefits would be needed before he would pay any taxes at all. Since the exemption and standard deduction amounts are indexed for inflation, this will increase beyond $80,000 in future years.

An average earner retiring at age 66 would draw somewhere around $16,000 in Social Security benefits. Social Security benefits are adjusted for inflation. Even so, at a modest 3% annual inflation rate it will be decades before he would have to pay taxes.

Let's compare our spendthrift to another average earner retiring at the same time who has saved enough for an initial withdrawal of $24000 from tax deferred savings with annual adjustments for inflation. The test amount for that person would be $32,000 and he would add $3500 of Social Security to his AGI and unless he had lots of deductions would pay taxes on it.

And as our conscientious saver increased his tax-deferred withdrawals for inflation, more and more of his Social Security benefits will be taxed. He's at the level where every $1 of additional taxable income results in taxation of $.50 of Social Security benefits. So instead of being in the 15% tax bracket, he's really in the 1.5 x 15% bracket or 22.5%. And if in the future the 15% bracket becomes 20%, his marginal tax rate is 30%. With more income such that $.85 of Social Security is taxed for each dollar of other taxable income, then his tax rate gets multiplied by 1.85. (Kind of hurts if the taxes were 15% or even 25% when deferred.) At a 3% inflation rate, the rule of 72 says that his tax-deferred withdrawals 24 years from now will be $48,000 and his Social Security benefit $32,000, of which $27,200 or the limit of 85% would be taxed.

And if he thought he could reduce his tax bill in retirement by investing in municipal bonds, guess what! The interest from the bonds is not taxed at the federal level, but the interest is added to the test amount used above to compute how much Social Security is added to his AGI. So he could effectively pay some federal taxes on it anyway. Don't be surprised if in the future Roth distributions are treated similarly.

At the same time, the spendthrift would be a long way from having any Social Security added to his AGI, and because of exemptions and standard deductions which would be inflation adjusted by then to $20,000 it would take even longer before inflation would result in his paying any taxes at all.

When this means-test equivalent was originally put in place, only the very wealthy were effected. With the inexorable march of inflation, more and more Boomers who have saved responsibly will pay more and more taxes. Taxes that will help pay the benefits for the irresponsible who haven't saved.


Solitary Dancer said...

Sorry it took so long to find my way over here. I love your site and I have to find time to read more of it.

I've just been buried lately and have not been posting as much as I would like.

But that's life!!! I'll add a link back to you. Good job, Good site


EMF (Engineer) said...

Deb, thanks for stopping by and the comment.

And maybe we can find some more boomer personal finance blogs, eventually.

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