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
Social Security is a FORCED pension. I never wanted it, but I had no choice. If I had been allowed to keep this money and invest it then it would have been worth a lot more than I’ll ever get now. Social Security was an awful idea at the outset, and it’s gotten much worse over the years. Putting that much money within the reach of politicians was pure folly. Taxing it would put a lot of people, who are struggling now, out on the street. Great idea Zelinsky!
What a horrible idea. I understand where you are trying to go in calculating the basis, and ‘taxing’ the payments after the basis is returned. But comparing to the private pension or 401(k) system is a poor comparison. With the private pension system, there is some expection of growth over the long term. So you may retire with $500k in your plan, but your basis might only be $100k. It’s comparing apples to apples. Social Security should be completely disbanded. It is beyond repair at this point and the only way to ‘save’ it is to add to our already overburdened tax system significantly. And that will be much too painful for our eoncomy in the long term.
This just makes sense. After all, social security contributions are tax deferred already.
And we should be looking at simplification of the tax forms also. The alternative minimum tax could be removed, and all deductions should be reformulated as tax credits at 20% of the amount too. In that way everybody would get the same subsidy for a dollar of mortgage interest instead of the rich getting more subsidy than the poor!
85% of my Social Security is taxed already regardless of whether I have recovered my contributions or not. My contributions were subject to income tax when paid in (FICA tax is not deductible for income tax purposes). This is double taxation as I see it, and was part of the Clinton tax increases.
The Congress giveth and the Congress taketh away!
Social security taxes were set up to provide more than just an old age pension and the amounts paid out to the individual are more heavily weighted towards the poor that worked at lower wages. The caps on contributions are illogical. If one makes $100,000 per year, one receives less per dollar of contribution than a person that makes only $25,000 per year. Unless you subscribe to throwing the poor under the bus and letting them sleep under a bridge, it makes sense to remove the cap on taxed earnings. That would put more of the burden on those that can most afford it. It would be even fairer to tax all income and lower the rates on wage earners.