Social Security’s Largest Raise Since 1982 Comes With Bad News for Retirees

Inflation rocketed to a four-decade high this year, so Social Security benefits will get an unusually large 8.7% COLA (cost-of-living adjustment) in 2023. That ranks as the largest raise for retired workers since 1982 and the fourth-largest raise in history. While that certainly qualifies as good news, the historic COLA may come with two unpleasant surprises.

Here are the details retired workers need to know.

Image source: Getty Images.

More retired workers will owe federal income tax on Social Security benefits

Initially, Social Security benefits were exempt from federal income tax. But Congress changed the law in 1983, authorizing the taxation of benefits for individuals whose income exceeded certain thresholds. A second (higher) threshold was added in 1993.

Oddly, those thresholds have never been adjusted for inflation. That is problematic because benefits have been adjusted for inflation. In other words, each COLA applied to benefits since 1983 has pushed more beneficiaries over the income thresholds. In fact, less than 10% of beneficiaries owed taxes on Social Security income when the law went into effect, but that figure is around 50% today, and a big COLA in 2023 will add momentum to the problem.

In most cases, beneficiaries who derive all of their income from Social Security will not pay taxes on benefits. But those with additional sources of income — such as a job, 401k distributions, or traditional IRA distributions — may find themselves on the wrong side of the income thresholds next year.

Tax liability depends on (1) filing status and (2) combined income, which is defined as the sum of modified adjusted gross income plus one-half of Social Security benefits. Here are the details:

Single taxpayers: If combined income falls between $25,000 and $34,000, up to 50% of Social Security benefits are taxable; if combined income exceeds $34,000, up to 85% of Social Security benefits are taxable.

Married taxpayers (filing jointly): If combined income falls between $32,000 and $44,000, up to 50% of Social Security benefits are taxable; if combined income exceeds $44,000, up to 85% of Social Security benefits are taxable.

Beneficiaries who owe taxes on Social Security benefits have two options. They can either make quarterly estimated payments to the Internal Revenue Service, or they can request that federal taxes be withheld from benefits by completing a Form W-4V.

Also noteworthy, retired workers should bear in mind that 12 states tax Social Security benefits, too.

The Social Security trust fund may be depleted earlier than anticipated

The aging Baby Boomer population has created a financial problem for the Social Security program: Costs are rising more quickly than revenue. In fact, the Social Security program ran a $56 billion deficit in 2021, and that trend is expected to continue indefinitely.

So what? The Social Security trust fund is on track to be depleted by 2035, and the program is facing a $20 trillion shortfall through 2096, according to the Board of Trustees. That does not mean retired workers will completely lose benefits, but it could lead to a pay cut if Congress fails to resolve the problem. Specifically, if the trust fund is depleted by 2035, income taxes would cover only 80% of scheduled benefits.

Unfortunately, the Board of Trustees did not anticipate an 8.7% COLA in 2023. The projections discussed in the previous paragraph are based on the assumption that benefits would rise by no more than 5.14% next year. In other words, the unusually large Social Security COLA could accelerate the depletion of the Social Security trust fund.

On the bright side, the politicians in Washington are well aware of the problem, and many government officials have proposed potential solutions.

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