This 33-Year-Old Social Security Rule Is Wreaking Havoc on Seniors' Retirement Income

By Markets Fool.com


Image source: Flickr user Paloa Caruso.

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After working for four-plus decades in many instances, and paying into the Social Security program, today's seniors have come to rely heavily on their monthly benefit check.

Social Security: not so secure after all?
A Gallup poll released in October found that nearly six in 10 seniors relies on Social Security to comprise a "major source" of their retirement income, with another three in 10 counting on it as a minor source of income in retirement. Added together, we're looking at 90% of seniors reliant on Social Security to in some way meet their monthly expenses or provide a sound financial flooring during their golden years. Gallup's poll of pre-retirees showed a slight drop in expected reliance on Social Security once they reach retirement -- but make no mistake about it: Six in seven pre-retirees is still expected to count on Social Security income to help them meet their financial needs.

The big concern is that the program itself isn't on a solid foundation. With baby boomers leaving the workforce at a rate of about 10,000 people per day and expected to do so for the next decade and a half, the worker-to-beneficiary ratio is falling. Or in simpler terms, there's just not enough new workers entering the workforce to generate enough new payroll tax revenue to cover the massive number of pre-retirees set to hang up their gloves for good. This means the cash inflow into the program is set to turn into a sizable deficit that eventually, according to the Board of Trustees' 2015 report, exhausts the cash reserves of the trust by 2034.

The other "issue" is that seniors are living longer than ever thanks to improved medicines, access to healthcare, and health education. The average 60-year-old today is going to live about 21 years, which is great news for people who want to enjoy their retirement. The downside is it means more strain on the Social Security system which wasn't originally designed to make regular payouts to seniors in their 80s, 90s, and even 100s.

Should Congress continue to sweep this problem under the rug, a benefit cut of up to 21% could be needed by 2034 to sustain the programs payouts another 55 years. The potential for a benefit cut is just one factor seniors need to consider when decided when to claim benefits.

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Image source: Flickr user Mario Mancuso.

This 33-year-old Social Security rule is hurting most seniors
But there's an even bigger issue that's been plaguing the Social Security system for 33 years -- namely, the taxation of Social Security benefits based on income thresholds.

In 1983, Congress overwhelmingly passed amendments to Social Security that allowed the federal government to tax up to 50% of Social Security benefits on individual income above $25,000, and joint filers who reported income above $32,000. At the time this new amendment was only expected to affect about 10% of the population (i.e., upper-income earners).

In 1993, the Clinton administration passed legislation that wound up building upon the 1983 reforms. Instead of merely exposing 50% of Social Security benefits to the possibility of federal income taxes above the aforementioned thresholds, the Clinton administration instituted a new bracket that subjected up to 85% of Social Security benefits to federal taxation if individual income exceeded $34,000 annually, or if joint filers reported more than $44,000 in a calendar year. Up to 50% of Social Security benefits remained taxable within the following thresholds: $25,000 to $34,000 for individuals and $32,000 to $44,000 for joint filers.

Lawmakers' desire to collect tax on well-to-do individuals who could likely afford it made sense in 1983, and even 1993. But there's a problem with lawmakers' mode of thinking. While Social Security beneficiaries have witnessed their payouts rise in step with the rate of inflation over the past 33 years, the tax income thresholds are still stuck in the Stone Age, unchanged since 1983. This means if you're a single-filer bringing home more than $2,083 a month in retirement today, and you're receiving Social Security benefits, half of your benefits could be taxable. For couples earning more than $2,667 per month, the same could be said.

Uncle Sam wants his due. Image source: Pixabay.

Based on estimates from The Senior Citizens League (TSCL), more than half of all households were expected to owe some sort of tax on their Social Security benefits in 2015, which is a far cry from the roughly 10% of people the 1983 amendment was intended to target.

Furthermore, TSCL notes that if the tax thresholds had kept pace with the rate of inflation since 1983, in 2015 dollars they wouldn't kick in until $57,107 for individuals and $73,097 for joint-filers. These figures are a long way off from the current thresholds of $25,000 and $32,000, respectively, and it suggests that seniors could be losing thousands of dollars annually via federal income taxes because of a 33-year-old Social Security rule that Congress has seemingly forgotten about.

Be proactive
Seniors today really have two choices. Either they can hope Congress comes to its senses and substantially adjusts the Social Security income thresholds to put more money back into the pockets of middle-class seniors, or they can be proactive and make a few changes on their own instead of relying on the government.

Image source: Pictures of Money via Flickr.

One of the smartest ways seniors can reduce their taxes is by having a withdrawal plan firmly in place before retirement. If you've already retired, don't fret, it's never too late to formulate a withdrawal plan, or to revise an existing one.

Essentially, a withdrawal plan lays out how you're going to access your money during your golden years. This would include Social Security, any pensions you might receive, as well as investment income and disbursements. Taking your money too quickly could mean outliving your nest egg. But, pulling out a lot annually can also mean paying a lot in taxes. Planning your distributions ahead of time may allow you to avoid bumping up into a higher tax bracket, thus saving you money over the long run.

Another point that's alluded to above is that seniors really need to enter retirement with more sources of income than just Social Security. Considering that the program has an uncertain future in terms of maintaining current benefit levels, seniors need to have a Plan B in place. Investing for the future is a smart move since seniors are living longer than ever. A traditional investment account could be what the doctor ordered, or, even better, a Roth IRA, which would allow your investments to grow completely free of taxation as long as you're contributing money you won't need for at least five years.

It's unfortunate that Congress hasn't stepped up to correct what I view as an outdated Social Security rule, but understand that you always have opportunity to potentially boost your income and/or lower your tax rate in retirement.

The article This 33-Year-Old Social Security Rule Is Wreaking Havoc on Seniors' Retirement Income originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.