Tax Social Security and Railroad Retirement Benefits in the Same Way That Distributions From Defined Benefit Pensions Are Taxed

Background

Under current law, approximately 70 percent of the benefits paid by the Social Security and Railroad Retirement programs are not subject to the federal income tax. For recipients with income below a specified threshold, none of those benefits are taxable. Most recipients fall into that category, which represents the first of three income-based tiers. If the sum of a recipient's adjusted gross income, tax-exempt interest, and half of either Social Security benefits or Social Security-equivalent Tier I Railroad Retirement benefits exceeds $25,000 for single taxpayers or $32,000 for couples who file jointly, up to 50 percent of the benefits are taxable. Above a higher threshold—$34,000 for single filers and $44,000 for joint filers—as much as 85 percent of the benefits are taxable. (Adjusted gross income includes income from all sources not specifically excluded by the tax code, minus certain deductions.)

By contrast, distributions from defined benefit plans are taxable except for the portion that represents the recovery of an employee's "basis"—that is, his or her after-tax contributions to the plan. In the year that distributions begin, the recipient determines the percentage of each year's payment that is considered to be the nontaxable recovery of previous after-tax contributions; that determination is based on the cumulative amount of those contributions and projections of his or her life expectancy. Once the recipient has recovered his or her entire basis, all subsequent pension distributions are fully taxed. Aside from their treatment under the tax system, defined benefit plans are quite similar to the Social Security and Railroad Retirement programs.

In 2016, the Social Security Administration paid $911 billion in Old-Age, Survivors, and Disability Insurance benefits, and the Railroad Retirement Board paid $7 billion in Tier I Social Security-equivalent benefits. Altogether, the taxable amount of those benefits was $286 billion, as reported by the Internal Revenue Service, and taxes on that amount generated $56 billion in revenues. Benefit payments are projected to rise through 2028 as the population ages and members of the baby-boom generation retire, causing the number of beneficiaries to grow faster than the population. The amount of benefit payments that is taxable will grow faster than overall payments because the thresholds for determining the taxable portion are not adjusted for inflation.

Option

This option would treat Social Security and Railroad Retirement benefits in the same way that defined benefit pensions are treated—by defining a basis and taxing those benefits that exceed that amount. For employed individuals, the basis would be the payroll taxes they contributed to those programs (but not the equal amount that their employers paid on their behalf). For self-employed people, the basis would be the portion (50 percent) of their self-employment taxes that was not deductible from their taxable income.

Effects on the Budget

Under this option, revenues would increase by $411 billion from 2019 through 2028, the staff of the Joint Committee on Taxation estimates. That increase would be entirely due to higher taxes on the recipients of Social Security and Railroad Retirement benefits. Increases in revenues would be greater after temporary provisions of the 2017 tax act that lower ordinary rates and increase the standard deduction expire at the end of 2025.

The estimate reflects differences in the effects of the option among recipients of Social Security and Railroad Retirement benefits. The option would increase taxable income for many recipients both before and after they had fully recovered their past contributions to the system because the taxable portion of their benefits would increase. Some recipients would still not pay taxes on those benefits because they would have sufficient deductions and could make other adjustments, such that their overall taxable income would remain low enough for them to owe no federal income taxes.

The estimate for this option is uncertain because the underlying projection of Social Security and Railroad Retirement benefits is uncertain, as is the projection of payroll contributions that will determine both the benefit amount and the basis for future retirees. The estimate also relies on estimates of how taxpayers would shift their participation in the labor force in response to changes in their after-tax income from benefits.

Other Effects

An argument in favor of this option concerns equity. Taxing benefits from the Social Security and Railroad Retirement programs in the same way as those from defined benefit plans would make the tax system more equitable, in at least two ways. First, it would eliminate the preferential tax treatment that applies to Social Security benefits but not to pension benefits. For low- and middle-income taxpayers especially, that preference can cause elderly people with similar income to face very different tax liabilities depending on the mixture of retirement benefits they receive. Second, the option would treat elderly and nonelderly taxpayers with comparable income the same way.

Another benefit of the option is that it could simplify the preparation of tax returns for people who pay taxes on Social Security benefits under current law. Taxpayers currently have to calculate the taxable portion of those benefits themselves. Under the option, the Social Security Administration—which would have information on their lifetime contributions and life expectancy—would compute the taxable amount of benefits and provide that information to beneficiaries each year.

This option also has drawbacks. It would have the greatest impact on people who depend entirely on Social Security or Railroad Retirement benefits for their support. In addition, raising taxes on Social Security and Railroad Retirement benefits would provide current retirees or people nearing retirement little or no opportunity to adjust their saving or retirement strategies to mitigate the impact. The option could be phased in, but that would result in smaller revenue gains. Finally, the option would increase the number of elderly people who have to file tax returns, and calculating the percentage of each recipient's benefits that would be excluded from taxation would impose an additional burden on the Social Security Administration.