The Repeal of Taxes on Social Security Benefits

A Summary of the You Earned It, You Keep It Act

In recent news, the proposal to eliminate federal taxes on Social Security benefits has resurfaced, sparking excitement in the media and discussion among the public. This proposal called the “You Earned It, You Keep It Act”, introduced by Representative Angie Craig of Minnesota, has a headline benefit of eliminating the taxation of Social Security benefits. Additionally, as highlighted in a press release from Representative Craig’s office, the bill boasts the potential to extend the solvency of the Social Security Trust Fund to 2054—a notable extension from the current projection of 2034—while also promising to reduce the federal debt by $8.9 trillion over a span of 75 years.

Representative Craig herself champions the bill as a “win-win” solution, framing it as both a tax cut for seniors and a measure to fortify the reliability of Social Security benefits for all Americans. However, amidst the enthusiasm surrounding the proposal, there are reasons to be skeptical.

Historical Context: From Tax-Free Benefits to Taxable Income

To understand the significance of the current proposal, it’s essential to understand the history of Social Security taxation. Initially, Social Security benefits were not subject to federal taxes when the program was established in 1937. However, in 1983, the Greenspan Commission recommended taxing Social Security benefits as a solution to address the program’s financial challenges. As a result, legislation was passed to make up to 50% of an individual’s benefits taxable income.

Subsequently, in 1993, another law increased the taxation threshold, allowing up to 85% of Social Security benefits to be taxed. This change was justified based on the rationale that only a small portion of an individual’s lifetime benefit payments was funded by payroll taxes, making the majority of benefits considered taxable income. Furthermore, these taxation thresholds were not indexed to inflation, leading to an increasing number of retirees being subject to taxation over time.

Historical Context: From Tax-Free Benefits to Taxable Income

To understand the significance of the current proposal, it’s essential to understand the history of Social Security taxation. Initially, Social Security benefits were not subject to federal taxes when the program was established in 1937. However, in 1983, the Greenspan Commission recommended taxing Social Security benefits as a solution to address the program’s financial challenges. As a result, legislation was passed to make up to 50% of an individual’s benefits taxable income.

Subsequently, in 1993, another law increased the taxation threshold, allowing up to 85% of Social Security benefits to be taxed. This change was justified based on the rationale that only a small portion of an individual’s lifetime benefit payments was funded by payroll taxes, making the majority of benefits considered taxable income. Furthermore, these taxation thresholds were not indexed to inflation, leading to an increasing number of retirees being subject to taxation over time.

Understanding the Current Proposal

The “You Earned It, You Keep It” bill is grabbing headlines with its promise to return to the original principle of tax-free Social Security benefits. However, as the saying goes, “Sell the sizzle, not the steak,” and it appears that may be what’s going on here. What this new law is really about is not eliminating the taxes on Social Security benefits that are being paid to retirees, it’s about increasing taxes on workers who make over a certain amount.

Currently, individuals pay 6.2% of their income in taxes to support the Social Security system, but this tax is only applicable to income up to $168,600 in 2024. Any income beyond this threshold is not subject to the Social Security portion of the FICA tax. For instance, someone earning $200,000 would only pay the tax on the first $168,600 of their income and earn $31,400 free of this tax. Importantly, earnings above the limit do not contribute to future Social Security benefits either.

The proposal introduces a temporary “donut hole” where earnings up to the cap are taxable, with taxes kicking back in when earnings exceed $250,000. This means that earnings falling within this middle range would not be subject to the Social Security portion of the FICA tax.

However, it’s important to note that the cap increases annually based on changes to wage inflation. Estimates suggest that the cap could reach $250,000 by approximately 2035, effectively subjecting all earnings to the Social Security portion of the FICA tax at that point.

Implications and Considerations

Given that the existing Social Security formula is structured to compute benefits solely based on the prevailing maximum taxable wage base, any alteration to this base would necessitate a corresponding adjustment in the formula. Under this proposal, a new metric known as Average Indexed Monthly Earnings (AIME) would be introduced for earnings exceeding $250,000, labeled as AIME+. The primary insurance amount would then be credited at 2% of this additional amount. Essentially, for individuals mandated to commence paying substantially higher FICA taxes, the return on investment in terms of taxes paid vis-à-vis benefits received would markedly diminish.

Will You Earned It, You Keep It Become Law?

Ultimately, a new law that solely benefits higher-income retirees—those currently subjected to benefit taxation—while simultaneously imposing higher taxes on higher-income workers, seems unlikely to advance. Nevertheless, this proposal offers valuable insight into the legislators’ thought processes, highlighting their aim to render the Social Security system even more progressive than its current state.

Ultimately, the objective of such legislation is to augment the progressivity of the Social Security system. There are often conversations about the potential implementation of means testing for Social Security in the future. However, if you understand the mechanics of the current you know that the system already encompasses elements of means testing. With this proposed law, means testing would be expanded, potentially paving the way for a future scenario wherein Social Security benefits are unavailable to individuals surpassing certain income and savings thresholds.

Planning for Retirement: Strategies to Minimize Taxes

Regardless of the fate of this or any proposed legislation, it’s important for individuals nearing retirement to ensure they have a solid plan in place to mitigate taxes during their retirement years. This is an area where dedicating even a modest amount of effort to planning can yield significant benefits.

In addition to saving money on taxes, you might find yourself asking questions such as:

• How can I safeguard against the risk of running out of money?
• Should I contemplate Roth conversions?
• What is the most advantageous sequence for withdrawing funds from my retirement accounts?
• How do I coordinate my Social Security filing strategy with my other sources of income and assets?

Do any of these questions sound familiar? Wouldn’t it be comforting to obtain clarity and confidence, knowing you’ve made the optimal choices for yourself and your future? The good news is that now you can. You no longer need to wrestle with uncertainty, second-guessing, or doubt about whether you’re on the right track. We’re here to guide you through the maze of retirement planning, empowering you to craft a plan that secures the retirement you and your loved ones deserve. If you’d like to chat, please get in touch.