While inflation is challenging for everyone, those receiving Social Security benefits will be given some relief next year. The 2023 Cost of Living Increase (COLA) in Social Security will be 8.7%. This is the largest increase since the 1981 increase of 11.2%. Along with the COLA increase, those in the Medicare system will see a decrease in the base Part B premium of $5.20 per month - from $170.10 to $164.90.
I'm often asked how the COLA is determined. Social Security uses the Consumer Price Index for for Urban Wage Earners and Clerical Workers (CPI-W). The year over year change from October to October determines the increase, which begins with January payments the following year.
While getting an increase in benefits is a good thing, there are some tax issues to be considered. As Social Security benefits increase, so can taxes on these benefits. If a couple turning 66 and 6 months on January 1, 2023 were to receive maximum Social Security benefits, and they delayed filing until age 70, the would receive $55,710 each in benefits (not taking into account future COLAs). Based on the way taxation of benefits are calculated, only $15,954 of their combined benefits of $111,420 would be added to their Federal Adjusted Gross Income. This amount is higher than their 2022 standard deduction of $28,700 so their taxable income would be zero - and no federal taxes would be due. Good news right? It is until you start adding in other sources of income.
This couple may conclude that, because the difference from the standard deduction and the amount of their benefits included in AGI is $12,746, they could take IRA distributions of this amount and not owe any federal tax. They would be mistaken. The amount of your benefits subject to tax is based not only on the amount of your benefits, but also the amount of other income. Taking the IRA distribution of $12,746 increases the amount of their Social Security included in AGI to $26,788. That amount, along with the distribution, brings AGI up to $39,534, resulting in taxable income of $10,834.
Because they are in the 10% bracket, the tax is only $1,085 (not quite exactly 10% due to tax tables). However, their Social Security Marginal Bracket ( a term I created) is 18.50%. Each additional dollar of ordinary income they receive will - effectively - be taxed at 18.50%, not 10.0%. This is because each dollar of additional income causes another $0.85 of their Social Security benefits to be taxed.
Taxation of Social Security benefits adds a level of complexity to retirement tax planning that working people don't have. While it is confusing for most people to understand, Tax Acuity does all of the complicated calculations for you so you can show your clients exactly where they are in regard to taxation of their benefits.
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