The Social Security Inflation Problem

Shocked senior man looking at bills copy space
Shocked senior man looking at bills in disbelief, holding his glasses on forehead, copy space

Inflation continues to persist into the early Fall months of 2021 and Americans are facing more economic risks, including higher taxes on top of a reduction in purchasing power. Economists are currently predicting that the Social Security Administration will have to significantly increase social security benefits to counteract the rising rate of inflation. In doing so however, financial experts warn of a potential tax nightmare for retirees who exceed the Internal Revenue Service’s retirement income threshold. The official cost-of-living adjustment is expected to be announced later this month, but retirees should be prepared for the potential tax consequences of receiving increased social security benefits in 2022 and beyond. 

With inflation currently locked in at 5.3% year-over-year in August 2021, the Social Security Administration (SSA) is scheduled to announce what is projected to be the largest cost-of-living adjustment (COLA) to social security benefits in nearly 40 years. Currently, experts are estimating that the increase will exceed 6% to counteract the meteoric rise of inflation during the COVID pandemic. The last time the COLA was increased at a rate this large was in 1982, when the SSA increased benefits more than 7% during a year when inflation stretched above 6%. In recent years, inflation has not posed much of a threat to consumer spending and cost adjustments made by the Social Security Administration have not made a significant impact on received benefits. In fact, in 2019 and 2020, the COLA for social security benefits were increased by less than 2%. 

There are several reasons why this year’s COLA increase may cause some concerns for seniors who receive social security benefits. The first call for concern is the potential that increasing the COLA will subsequently cause retirees taxes to increase. Based on the tax regulation rules from the Internal Revenue Service (IRS), if a single, married, or joint tax filer has a combined income that exceeds the IRS income threshold, then their social security benefit will be subjected to income taxes. There are three income tiers that retirees can fall into in this scenario which dictate what percentage of their social security benefits will be subject to taxes—the first tier is 0% for any single filer that makes less than $25,000 in their combined income each year, or for any married couple who earns less than $32,000 a year. The second and third tier indicates that 50% or 85% of the recipients’ total benefit will be subjected to income taxes. 

Single individuals who have a combined earned income between $25,000 and $34,000 have up to 50% of their social security benefit subjected to income taxation according to IRS rules. Anything above $34,000 would increase the applicable percentage from 50% to 85%. Married couples’ income thresholds are slightly higher. A married couple earning between $32,000 and $44,000 each year would have up to 50% of their benefits subject to income taxes, and up to 85% if they earn more than $44,000 a year. Congress first approved this double tax into social security during the Reagan administration in the 1980s and the tax was later increased during the Clinton administration in the 1990s. 

This double tax is problematic for two reasons. First, Americans worked their entire lives and paid into the social security system with money that was taken from their paychecks with the intention of getting it back in the form of a fixed income when they reach retirement age. Essentially, Americans are paying a fee to the government to hold onto their money and then paying another fee when they activate their income stream—which is no better than how brokers treat retirement nest eggs. Secondly, the IRS income thresholds which determine what percentage of social security benefits are taxable are not inflation adjusted. Therefore, the percentage of households that will pay taxes on their social security benefits will inevitably increase over time unless the IRS either boosts their income thresholds or makes them inflation adjustable. 

As of 2020, the Center for Retirement Research estimated that 56% of households that receive social security benefits are anticipated to pay income taxes on the benefits that they receive. The percentage of households subject to this taxation is only going to increase as time passes because the income tax regulations that dictate when and how much of social security benefits are taxed are not inflation adjusted. As a result, in years with high rates of inflation (such as 2021), it can serve as a double-edged sword for retirees. Additionally, as social security COLA’s increase, so do premiums for Medicare Part B which is funded through social security benefits. In recent history, Medicare Part B premiums have risen at an average rate of 5.9% each year. 

Between inflation, taxes, and the rise of Medicare Part B premiums, the net social security benefit that retirees receive in 2022 may be canceled out, ultimately making a bad economic situation worse. Despite this, social security recipients will soon find out what the COLA will be for 2022 when the Social Security Administration makes their announcement in the next few weeks. One way that concerned or at-risk retirees can preemptively address this financial situation is by establishing a financial plan that reduces their overall tax liability to keep their money out of the government’s pockets and put back into their own.