We're now less than one week away from the biggest day of the year for Social Security's more than 65 million beneficiaries. On Thursday, Oct. 13, 2022, at 8:30 a.m. ET, the Bureau of Labor Statistics will announce the September inflation data, which provides the final puzzle piece needed to calculate Social Security's cost-of-living adjustment (COLA) for 2023.
Since 89% of retired workers rely on their monthly payout, to some degree, to make ends meet, knowing how much it's going up next year is incredibly important.
How is Social Security's cost-of-living adjustment (COLA) calculated?
The easiest way to think about Social Security's COLA is as the mechanism designed to account for the rising price of goods and services (i.e., what's commonly referred to as “inflation”). If senior citizens purchase a basket of goods and services with their Social Security income, and the price for those goods and services increases, benefits should, ideally, rise in lockstep to avoid a loss of purchasing power. COLA is what accounts for inflation and attempts to keep Social Security payouts on par with the rising price of goods and services.
Since 1975, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has been used to calculate COLA on an annual basis. It has more than a half-dozen major spending categories and dozens upon dozens of subcategories, each with its own respective percentage weightings. These weightings allow the CPI-W to be expressed as a single number, which can then be easily compared to the previous month or year to determine if inflation or deflation (falling prices) has occurred.
Calculating Social Security's COLA is a lot easier than you might realize. That's because only the third quarter (July through September) CPI-W readings are used in the calculation. If the average third-quarter CPI-W reading in the current year is higher than the average Q3 CPI-W reading in the previous year, inflation has occurred, and beneficiaries are in-line for a “raise.” The magnitude of the payout increase is the percentage difference from one year to the next, rounded to the nearest tenth of a percent.
Note, “raise” is in quotation marks to reflect that benefits increase to match inflation and aren't a true raise like what you'd get from an employer.
Social Security's historic “raise” is a two-sided coin
In 2023, Social Security's COLA is expected to be historically high. CPI-W data from July and August has the cost-of-living adjustment pacing at 8.8%. However, Social Security policy analyst Mary Johnson of The Senior Citizens League (TSCL) estimates that, once the September data is released, the final COLA will come in at 8.7% for 2023. For context, this would be the largest year-over-year percentage increase in 41 years, as well as the biggest nominal-dollar boost to Social Security checks in history.
Having done the math using Johnson's COLA estimate of 8.7%, the average retired worker can expect a $146 monthly “raise.” Meanwhile, the average disabled worker and survivor can expect respective increases of $119/month and $116/month.
However, Social Security's 2023 COLA isn't all the peaches and cream it's made out to be. Although Social Security checks are set to soar, retirees are likely going to hate three aspects of next year's historic “raise.”
1. Inflation could eat up a significant portion of next year's “raise”
To begin with, retirees are probably going to give back most or all of what they receive in extra benefits next year due to inflation. Remember, the only reason the cost-of-living adjustment is so high is that the price for goods and services has rocketed higher. It's going to take time for shelter, food, and energy inflation to taper, which means retirees will be spending some or all of next year's “raise.”
If there is a bit of a silver lining here, it's that the Medicare Part B premium — Part B covers outpatient services — will decline by approximately 3% in 2023. Most retired workers are enrolled in Medicare and have their Part B premium automatically deducted each month. A year-over-year decline in the Part B premium has only happened a couple of times over the past quarter of a century, and it could result in seniors getting to hang on to a bit more of their “raise” than usual next year.
2. Even a mammoth COLA can't offset a persistent loss of purchasing power
The second thing retirees aren't going to be happy about is the persistent loss of purchasing power they're contending with. According to a May report from TSCL, the purchasing power of Social Security income has plunged 40% since 2000. In other words, what $100 in Social Security income used to buy can now only purchase $60 worth of those same goods and services.
The culprit for this ongoing loss of purchasing power is the CPI-W. While shifting to an annual inflationary tether in the mid-1970s was a smarter move than arbitrarily passing along COLAs via special sessions of Congress, the CPI-W has an inherent flaw. Namely, it tracks the spending habits of “urban wage earners and clerical workers.” These are typically working-age people who aren't receiving a Social Security benefit and spend their money very differently than aged Americans. The end result is that important costs for retirees, such as medical care and shelter, aren't receiving a proper weighting in the COLA calculation. Over the past 22 years, this has led to the noted 40% loss of purchasing power.
No matter how high COLA comes in for 2023 — and the years thereafter — it's going to be virtually impossible for retirees to make up much, if any, of this lost purchasing power.
3. Get ready for a larger tax burden
The third aspect retirees are going to hate about 2023's robust cost-of-living adjustment is the likelihood of a larger tax burden.
In 1983, with Social Security's asset reserves running on fumes, Congress passed and President Ronald Reagan signed into law the last major overhaul of America's most successful retirement program. The Social Security Amendments of 1983 gradually increased the payroll tax rate and full retirement age, as well as introduced the taxation of benefits.
Initially, half of a recipient's benefits could be subject to federal taxation if their modified adjusted gross income (MAGI) plus one-half of benefits paid topped $25,000 (or $32,000 for couples filing jointly). In 1993, the Clinton administration added a second tier, which allows up to 85% of benefits to be taxed at the federal rate if the MAGI plus one-half benefits formula tops $34,000 for a single filer or $44,000 for a couple filing jointly.
The income thresholds that were introduced in 1983 and 1993 have never been adjusted for inflation. Therefore, every single annual COLA ensures that additional retirees and more Social Security dollars are subject to federal taxation.
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