When helping clients plan their Social Security benefits we used to be able to tell them that, if the only income they receive in retirement is Social Security, none of it would be taxed - even if both were receiving the maximum benefit delayed until age 70. This is still the case today, but a time will come when we can no longer make this statement.
According to the Social Security Administration, the maximum benefit in 2021 for a person filing at age 70 is $3,895. For a couple, both receiving the maximum, they would receive $93,480 in total benefits. Currently, none of it will be taxed. Due to the way taxation of benefits is calculated they would have $8,329 of these benefits added to Adjusted Gross Income. Because the total standard deduction for a couple at age 70 is $27,800 their taxable income will be zero, so no taxes will be due.
As other income is added in, more of the benefits are added to AGI. If they only add $10,526 of ordinary income from interest, IRA distributions, etc., $17,276 of their benefits are added to AGI, giving them total AGI of $28,802 which now gives them taxable income - I know, it is only $2 but I want to demonstrate the break-even. By the way, having tax-exempt income from municipal bonds doesn't relieve them from taxation. If this couple had $22,910 of tax exempt interest - which is added into the formula to determine taxation of Social Security - $27,803 of their benefits will be added to AGI, giving them taxable income.
So how is inflation catching up to Social Security? It is happening in three ways. First, the limits on taxation of benefits were set in 1983 and have never been indexed for inflation. Taxation of benefits is based on a formula that adds your Adjusted Gross Income before Social Security plus one-half of your Social Security plus Tax Exempt interest. Benefits for a single person begin to be included in AGI once this amount exceeds $25,000; for married couples the amount is $32,000. The earliest the Social Security Administration has records for maximum benefits goes back to 1987. At that time, the maximum benefit for someone filing at age 70 was $1,056. A couple receiving the maximum benefit, at the time, wouldn't be concerned about it being taxed.
So, when will a point be reached that Social Security benefits will be taxable - even if that is the only income that a couple has? Mark your calendar for 2030. At that point, based on historical cost of living adjustments, the maximum benefit at age 70 will be $5,045. Assuming the Tax Cuts and Jobs Act of 2017 (TCJA) sunsets in 2025, which it will if congress takes no action, the standard deduction will be about $19,370. Tax brackets, and the standard deduction, are now indexed using the Chained Consumer Price Index for all Urban Consumers (C-CPI-U), while Social Security uses the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The C-CPI-U has grown at about 0.25% less than CPI-W based on data from the Congressional Budget Office. Therefore, benefits are going up faster than the Standard Deduction, which will also be cut roughly in half once the TCJA sunsets. The three drivers affecting taxation of Social Security are: Social Security Cost if Living Adjustments growing using the CPI-W, the lower standard deduction in 2026, and the standard deduction increasing using the slower moving C-CPI-U.
So what does this mean for people retiring over the next few years? The same advice we have always given still applies. The higher the ratio of Social Security is to other income, all other things being equal, the lower your taxes will be. If possible, delaying Social Security helps in four ways:
Obviously, you will have higher benefits
The survivor benefit will be higher
More of you income will be inflation protected (COLAs on Social Security)
You will need less from your investments to cover your expenses, potentially allowing your investments to last longer
Tax Acuity allows you to easily model how changes in Social Security affects your overall tax situation.
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