Why do We Tax Social Security Benefits?

Social Security has been a frequent topic of discussion recently with its future financial health in question and many future retirees are wondering if they can count on these benefits to help fund their retirement.

According to Social Security Commissioner Michael Astrue, Social Security is the largest source of income for most elderly Americans today. But should it be considered a retirement plan? It’s not nearly enough to live on, but the fact that you must wait until you are at least 62 to collect a monthly allotment puts it in that category. However, the benefits are intended to supplement other retirement plans.

If it were a bona fide retirement program, either the contributions you make over the years would be sheltered from tax much in the same way funds put aside to your IRA or 401(k) are sheltered or the distributions you take at retirement would be free from taxation. But that is not the case, you pay in with funds already taxed and upon retirement, depending upon your income level, those benefits may be subject to income tax.

American workers fund the system: 6.2% for Social Security up to wages earned of $110,100 and 1.45% (unlimited) for Medicare comes out of your paychecks to fund your accounts. Your employer matches your contribution. As part of the payroll holiday program, during 2011 and 2012 your Social Security contribution was reduced to 4.2%. The employer share remained at 6.2%. If you are self-employed, you pay in a total of 15.3%, which are the employee/employer combined rates and is referred to on your tax return as “self-employment tax.”  Self-employed individuals do not enjoy the payroll holiday program with the reduced withholding the way wage earners can.

On an annual basis, the Social Security Administration sends a statement that shows how much you have contributed over the years and how much you will receive at retirement. You can begin collecting reduced benefits as early as age 62. However, if you continue to work, you are limited on how much you may earn before you must repay some benefits. This is not a factor once you reach full retirement age. For those born before 1938, full retirement age is 65. Those born thereafter and before 1960 enjoy a full retirement age of 66. The retirement age will be 67 for those born in 1960 and later thanks to a 1983 law change.

Social Security benefits could be taxable if you earn more than $25,000 per year if you are single and $32,000 per year if you are married filing joint. Note the marriage penalty. In a fair world the income figure for married filing joint would be $50,000.

The formula for determining taxability is not straight forward. You must add up all other taxable income plus tax exempt interest and include half of your social security benefits to determine if up to 85% of your Social Security benefits are taxable.

I know the government needs money to close the deficit, but taxing Social Security benefits is unfair because these funds were taxed when the contributions were made.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.