By Edward Zelinsky
President Obama’s National Commission on Fiscal Responsibility and Reform is reportedly forging an internal consensus concerning the federal Social Security system. The President’s bi-partisan deficit reduction commission is purportedly developing a package of reforms including higher retirement ages for Social Security eligibility, reduced cost-of-living adjustments for Social Security payments, and higher taxes.
As one who favors this type of balanced compromise, let me suggest one particular reform on the tax front: After Social Security recipients have recovered an amount equal to the cumulative FICA and self-employment taxes they have paid while working, their Social Security payments should be fully subject to federal income taxation. This change would make the Internal Revenue Code fairer and simpler while increasing federal revenues.
This approach would create tax parity between employer-sponsored pensions and Social Security, the pension plan sponsored by the federal government. Taxing Social Security benefits would also create tax parity between Social Security recipients and working individuals who include in their gross incomes for federal income tax purposes all of their wages. Taxing Social Security payments would not affect less affluent Social Security recipients since individuals wholly dependent on modest Social Security payments would in any event have too little income to pay any federal income tax.
Today, the federal income taxation of Social Security payments is governed by Section 86 of the Internal Revenue Code. Section 86 is a mess, one of the most unnecessarily convoluted provisions of the federal tax law. In any tax year, Section 86 first requires a Social Security recipient to determine her “modified adjusted gross income,” i.e., her adjusted gross income increased by several items including tax-exempt interest earned during the year. To her modified adjusted gross income for the year, the Social Security recipient then adds one-half of the Social Security payments received during the year.
This sum is then compared to a “base amount.” For an individual, this base amount is $25,000. For a married couple, this base amount is $32,000. To the extent that this comparison with the appropriate base amount reveals an excess, the taxpayer then contrasts half of that excess with half of his Social Security benefits and includes in his gross income the smaller of these two numbers. A second and equally complicated formula applies to more affluent Social Security recipients.
To see the overly-complex Section 86 in action, assume that, in 2010, a widower receives $12,000 in dividends plus $18,000 in Social Security payments. In this case, his modified adjusted gross income is $12,000, the amount of his dividends. When that amount is added to half of his annual Social Security payments ($9,000), the resulting total of $21,000 is less than the base amount of $25,000 for a single person. Thus, for federal income tax purposes, this individual includes none of his Social Security payments in his gross income.
Between his dividends and Social Security payments, this individual has annual income of $30,000 but only pays income taxes on $12,000. Contrast this favorable treatment with a younger individual who earns $30,000 by working. For federal income tax purposes, this younger individual’s gross income includes this entire amount.
In lieu of the complexity and unfairness of Section 86, a Social Security recipient should simply include in his gross income all of his Social Security benefits, once he has received benefits equal to the FICA and self-employment taxes he paid during his lifetime. Under this approach, distributions from Social Security, a government-sponsored pension plan, would be taxed more like distributions from employer-sponsored pensions. Moreover, the least affluent Social Security recipients, those living solely on modest Social Security payments, will not pay federal income taxes since their gross incomes, consisting solely of their Social Security benefits, will be offset for tax purposes by the personal exemptions and the standard deductions to which they are entitled.
In 2010, an elderly individual will, as a result of his personal exemption and standard deductions, pay no federal tax on the first $10,750 of his income. In June of 2010, the average monthly Social Security payment was $1,069. Hence, roughly half of Social Security recipients will, assuming they have no other income, pay little or no federal income tax, just as a younger person earning such modest income pays no federal income tax. However, Social Security recipients receiving more or receiving other income would contribute to the federal fisc, as do working individuals and private pension recipients with equivalent incomes.
In the final analysis, Social Security is a pension. An individual who receives an employer-sponsored pension pays federal income tax on his payments reduced by his own contributions (if any) to the pension fund. The same formula should apply to the government-sponsored pension. Changing the Internal Revenue Code in this fashion would establish tax parity between Social Security recipients and private pension recipients as well as between Social Security recipients and working individuals. And it would raise much-needed revenue.
Replacing Section 86 and its currently convoluted tax treatment of Social Security payments should be part of a balanced package of Social Security reforms advanced by President Obama’s deficit commission.
Edward A. Zelinsky is the Morris and Annie Trachman Professor of Law at the Benjamin N. Cardozo School of Law of Yeshiva University. He is the author of The Origins of the Ownership Society: How The Defined Contribution Paradigm Changed America