This Social Security Tax Makes No Sense Whatsoever

Source: Gareth Williams via Flickr.

With tax season winding down, many Social Security recipients have gotten the bad news that they'll have to include a portion of their monthly benefits as taxable income on their 2014 returns. For retirees, having to pay income tax on Social Security benefits puts further strain on already hard-hit finances at a time in their lives when they're least able to handle additional financial burdens.

Yet an even more onerous aspect of Social Security taxation hits those who receive disability benefits under Social Security Disability Insurance. Shockingly, some of the same tax rules apply to Social Security disability benefits, and they make even less sense for individuals who in many cases are suffering from debilitating diseases and bear the often high costs of dealing with them. Let's take a closer look at how Social Security disability benefits get taxed and why it makes so little sense.

How Social Security benefits got so taxingMany people don't fully understand when they have to include retirement benefits in taxable income. To determine whether you might owe some tax on your benefits, take half of what you get from Social Security and add in other income from wages, taxable pensions, investment income, and other sources. If the resulting amount is above $25,000 for single filers or $32,000 for joint filers, then you'll have to add a portion of your benefits to your overall taxable income in figuring your tax bill.

Many of those who receive disability benefits never even think to consider that the rules for taxing retirement benefits might apply to them. But surprisingly, the exact same rules govern Social Security disability, so if your income is above those levels, then you can expect the IRS to claim its share and effectively take back the benefits you depend on.

Image: SSA.

Why taxing disability benefits is sillyThere are several reasons why it makes little sense for the government to tax Social Security disability benefits. The most obvious one is that disability insurance programs are designed to help people who no longer have the ability to earn income on their own, so taxing the payments they receive effectively amounts to an artificial reduction to their benefits.

Disability recipients who are married especially feel the impact of Social Security taxation. Retired couples are typically close to the same age and therefore rely largely on Social Security income for their cash flow. However, for couples in which one spouse has a disability, the other spouse often works as hard as possible to make up for the lack of a second income. The resulting boost in wage and salary raises the couple's gross income, making a larger amount of Social Security disability income subject to tax and further penalizing families who are trying to make ends meet on their own.

Yet the biggest argument in favor of leaving disability benefits untaxed is that the tax system otherwise treats disability-related payments differently from retirement payments. Most private retirement payments that retirees receive are fully taxable, with a few exceptions such as Roth IRAs. That's because most workers get a tax break when they contribute to retirement plans, so the IRS gets its money back when you withdraw money after you retire.

Image: SSA.

By contrast, private disability insurance payments are often tax-free. If you pay the cost of a disability insurance policy with after-tax funds, then none of the benefits you receive are included in your taxable income. Only if your employer pays the cost of disability insurance do benefits become taxable.

Making the case for taxationThat last distinction is a central argument of those who favor taxing Social Security disability. Because your employer pays one-half of the total Social Security payroll taxes that go toward funding retirement and disability payments, policymakers argue that it makes sense to tax that portion of any benefits. Indeed, that was one of the justifications for initially setting a 50% maximum on the amount of benefits included in taxable income, with the later rise to an 85% maximum stemming from the notion that the higher income threshold amounts justified a greater percentage.

Tax theory aside, though, the impact on families with disabled persons can be huge. Because benefits are taxed based on gross income, itemized deductions like medical expenses aren't taken into account in determining taxability. The boost in taxable income can be enough to force people to pay tax even if their medical expenses would otherwise have been enough to wipe out any tax liability.

With so many financial issues already plaguing Social Security, a change to tax policy on Social Security disability isn't politically feasible in the short run. Eventually, though, policymakers might recognize that taxing disability benefits simply doesn't make sense and could incorporate a change into broader reform when it happens.

The article This Social Security Tax Makes No Sense Whatsoever originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.