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Social Security: Taxation of Benefits

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Social Security: Calculation and History of Taxing Benefits Christine Scott Specialist in Social Policy February 20, 2013Noah P. Meyerson Analyst in Income Security April 9, 2014 Congressional Research Service 7-5700 www.crs.gov RL32552 CRS Report for Congress Prepared for Members and Committees of Congress Social Security: Calculation and History of Taxing Benefits Summary Social Security provides monthly cash benefits to qualified retirees,retired or disabled workers, and their spouses and dependents. Until 1984, Social Security benefits were exempt from the federal income tax. In and their family members, and to the family members of deceased workers. Those benefits were exempt from federal income tax, but in 1983, Congress approved recommendations from the National Commission on Social Security Reform (also known as the Greenspan Commission) to tax Social Security benefits above a specified income threshold. Specifically, beginningthe benefits of some higher-income Social Security beneficiaries. Beginning in 1984, up to 50% of Social Social Security and Railroad Retirement Board (RRB) Tier 1Tier I benefits arewere taxable for individuals whose provisional income exceeds $25,000. The threshold is $32,000 for married couples. Provisional income is defined as the equals adjusted gross income (total income from all sources recognized for tax purposes ) plus certain otherwise tax-exempt income, including half of Social Security and RRB Tier 1Railroad Retirement Tier I benefits. The proceeds from taxing Social Security and Railroad Retirement Tier I benefits at up to the 50% rate are credited to the Old-Age and Survivors Insurance (OASI) trust fund, the Disability Insurance (DI) trust fund, and the Railroad Retirement system respectively, based on the source of the benefit taxed. In 1993, Congress passed a second income threshold for the calculation of taxable Social Security and RRB Tier I benefits. This second threshold (often referred to as Tier 2)the Omnibus Budget Reconciliation Act (OBRA) increased the share of some Social Security and Railroad Retirement Tier I benefits that are taxable. That law taxes up to 85% of benefits for individuals whose provisional income exceeds $34,000 and for married couples whose provisional income exceeds $44,000. The taxadditional proceeds from the second tier go to the Medicare Hospital Insurance (HI) Trust Fund. Income from taxation of benefits to the Social Security trust funds totaled $23.8 billion in 2011, or 3.0% of its total income. For Medicare, income from taxation of benefits totaled $15.1 billion in 2011, or 2.8% of total HI trust fund income. Because the income thresholds to determine the taxation of Social Security benefits are not indexed for inflation or wage growth, the share of beneficiaries affected by these thresholds is expected to increase over time. According to the Congressional Budget Office (CBO), 39% of (or 16.9 million) Social Security beneficiaries were affected by the income taxation of Social Security benefits in 2005that law are credited to the Medicare Hospital Insurance (HI) Trust Fund. In 2013, the federal government received $35.4 billion in revenue from taxation of those benefits. Of that, $21.1 billion was credited to the Social Security trust funds, accounting for 2.5% of its income. The remaining $14.3 billion was credited to the Medicare trust fund, which equaled 5.7% of its income. According to the Congressional Budget Office (CBO), 39% of Social Security beneficiaries (16.9 million people) were affected by the income taxation of Social Security benefits in 2005 (the most recent year for which the analysis is available). That share grows over time because the income thresholds used to determine the share of benefits that is taxable are not indexed for inflation or wage growth. As a result, income taxes on benefits will become an increasingly important source of income for Social Security and Medicare. Congressional Research Service Social Security: Calculation and History of Taxing Benefits Contents Calculation of Taxable Social Security Benefits.............................................................................. 1 Special Considerations .............................................................................................................. 46 State Taxation ............................................................................................................................ 56 Taxation of Social Security Benefits by Income Level.................................................................... 7 Impact on the Trust Funds ............................................................................................................... 9 History of Taxing Social Security Benefits...................................................................................... 9 10 Figures Figure 1. Taxable Social Security Benefits as Annual Non-Social Security Income IncreasesNon-Social Security (and Provisional) Income Increases for a Single Retiree with $15,139 in Annual Social Security Benefits, Tax Year 2012 .......................................................................................... 5 Figure 2.Taxable Social Security Benefits as Total Annual Social Security Benefits Increase ..................................... 4 Figure 2. Taxable Income for an Average Single Retiree ................................................................. 7 Figure 3. Taxable Income for a Single Retiree with $20,000 or $30,000 in Non-Social Security Income as Annual Social Security Benefits Increase, Tax Year 2012 ................................... 86 Tables Table 1. Calculation of Taxable Social Security and Tier I Railroad Retirement Benefits .............. 2 Table 2. Example of Calculation of Taxable Social Security Benefits for Average Social Security Recipient and Different Assumptions aboutSingle Social Security Recipients with a $15,000 Benefit and Different Levels of Other Income .......................................................... 3 Table 3. State Income Taxation of Social Security Benefits, Tax Year 20112014 ................................... 57 Table 4. Number and Percentage of Beneficiaries with Taxable Social Security Benefits by Income Class Under 2005 Law and Income Levels ................................................................ 68 Table 5. Social Security Benefits and Taxes on Social Security Benefits by Income Class Under 2005 Law and Income Levels ............................................................................................ 9 Appendixes Appendix. Special Considerations Under Taxation of BenefitsTaxation of Benefits Under Special Situations ............................................................ 13 Contacts Author Contact Information........................................................................................................... 15 Congressional Research Service Social Security: Calculation and History of Taxing Benefits T he Social Security system provides monthly benefits to qualified retirees, disabled workers, and their spouses and dependents. UntilBefore 1984, Social Security benefits were exempt from the federal income tax. Then in 1984, Congress enacted legislation to begin to tax Social Security benefits with a formula for determining taxable benefits that gradually Congress then enacted legislation to tax a portion of those benefits, with the share gradually increased as a person’s income rose above a specified income threshold. In 1993, a second income threshold was added that increased the share of benefits that are taxable. These two thresholds are often referred to as Tier 1 and Tier 2first tier and second tier. Calculation of Taxable Social Security Benefits In general, the Social Security and Tier I Railroad Retirement1 benefits of most recipients are not subject to the income tax. However, up to 85% of Social Security and Tier I Railroad Retirement benefits can be included in taxable income for recipients whose “provisional income” exceeds either of two statutory thresholds (based on filing status).2 “Provisional income” is total is adjusted gross income,3 plus certain otherwise tax-exempt income (tax-exempt taxexempt interest), plus the addition (or adding back) of certain income specifically excluded from federal federal income taxation (interest on certain U.S. savings bonds,4 employer-provided adoption benefits, foreign earned income or foreign housing, and income earned in Puerto Rico or American Samoa by bona fide residents), and plus one-half (50%)plus 50% of Social Security and Tier I Railroad Retirement benefits. The thresholdsbenefits. The first tier thresholds, below which no Social Security or Tier I benefits are taxable, are $25,000 for taxpayers filing as single, head of household, or qualifying widow(er) and $32,000 for taxpayers filing a joint return. A taxpayer who is married filing separately who has lived apart from his or her spouse all tax year has a threshold amount of $25,000. A taxpayer who is married filing separately who lived with his or her spouse at any point during the tax year, has a threshold amount of $0In the case of taxpayers who are married filing separately, the threshold is also $25,000 if the spouses lived apart all year, but it is $0 for those who lived together at any point during the tax year. If provisional income is between the first tier thresholds of $25,000 (single) or $32,000 (married couple) and the second tier thresholds of $34,000 (single (for single filers) or $44,000 (married couple), the for married couples filing jointly), the amount of Social Security and Tier I benefits subject to tax is the lesser of (1) one-half (50%) of 50% of Social Security and Tier I benefits;benefits or (2) one-half (50%) of 50% of provisional income in excess of the first threshold. If provisional income is above the second tier threshold, the amount of Social Security benefits subject to tax is the lesser of (1) 85% of benefits or (2) 85% of provisional income above the 1 Tier I railroad retirement benefits are paid to a qualified railroad retiree who has met the quarterly work requirements for Social Security benefit eligibility. The retiree receives Social Security benefits based on the work history that qualified the retiree for Social Security benefits, and the retiree receives Tier I benefits based on both the Social Security and railroad work histories. The actual Social Security benefits received are subtracted from this calculation of Tier I benefits to get actual Tier I benefits. See CRS Report RS22350, Railroad Retirement Board: Retirement, Survivor, Disability, Unemployment, and Sickness Benefits, by Scott D. Szymendera. In this report, references to Social Security benefits generally also apply to Tier I benefits. 2 For additional information on calculating taxable Social Security benefits, see U.S. Department of the Treasury, Internal Revenue Service, “Social Security and Equivalent Railroad Retirement Benefits,” Publication 915, 2006, available online at at http://www.irs.gov/pub/irs-pdf/p915.pdf. 3 TotalAdjusted gross income is the total of income from all sources recognized for tax purposesmain measure of income used when computing income taxes. The Internal Revenue Service refers to provisional income as modified adjusted gross income. See Publication 915 for details on the sources of income included in computing provisional income. 4 Interest on qualified U.S. savings bonds used to pay certain educational expenses is exempt from federal income taxation. Congressional Research Service 1 Social Security: Calculation and History of Taxing Benefits If income is above the second tier threshold, the amount of Social Security and Tier I Railroad Retirement benefits subject to tax is the lesser of (1) 85% of Social Security and Tier I benefits; or (2) 85% of provisional income above the second threshold, plus the smaller of (a) $4,500 (single) or $6,000 (married couple);5 or (b) one-half (50%) of Social Security and Tier I for single filers) or $6,000 (for married filers)5 or (b) 50% of benefits. Because the threshold for a married taxpayertaxpayers filing separately who has lived with his or her spouse athave lived together any time during the tax year is $0, the taxable benefits in such a case are the lesser of 85% of Social Security and Tier I benefits or 85% of provisional income. None of the thresholds are indexed for inflation or wage growth. Table 1 summarizes the thresholds and calculation of taxable Social Security and Tier I Railroad Retirement taxable benefits. Table 1. Calculation of Taxable Social Security and Tier I Railroad Retirement Benefits Provisional Incomea Calculation of Taxable Social Security and Tier I Railroad Retirement Benefits Provisional Incomea Single Taxpayer Less than $25,000 No taxable Social Security or Tier I Railroad Retirement benefitsNone $25,000 less thanto $34,000 Lesser of (1) 50% of Social Security and Tier I benefits;benefits or (2) 50% of provisional income above $25,000 $34,000 and over (maximum of $4,500) Over $34,000 Lesser of (1) 85% of Social Security and Tier I benefits;benefits or (2) 85% of provisional income above $34,000 plus lesser of (A) $4,500; or (B) 50% of Social Security and Tier I benefits Married Taxpayer Less than $32,000 No taxable Social Security or Tier I Railroad Retirement benefits $32,000 less thanamount in box above Married Taxpayer Less than $32,000 None $32,000 to $44,000 Lesser of (1) 50% of Social Security benefits;benefits or (2) 50% of provisional income above $32,000 $44,000 and over (maximum of $6,000) Over $44,000 Lesser of (1) 85% of Social Security benefits;benefits or (2) 85% of provisional income above $44,000 plus lesser of (A) $6,000; or (B) 50% of Social Security and Tier I benefits Source: Table prepared by the Congressional Research Service (CRS). a. Provisional income is totalamount in box above Source: Internal Revenue Service, Publication 915, “Social Security and Equivalent Railroad Retirement Benefits.” a. Provisional income is adjusted gross income plus certain income exclusions plus one-half (50%)50% of Social Security benefits. The following two examples in Table 2 illustrate how taxable Security benefits may be calculated for a single retiree in tax year 20122014. The retiree is at least 62 years of age, and receives $15,139in 5 The $4,500 (single) and $6,000 (married couple) 000 in annual Social Security benefits—about the average for a retired worker.6 The examples include other (non-Social Security) income of $20,000 or $30,000. 5 The $4,500 and $6,000 amounts are the maximum taxes for the Tier Ifirst tier calculation, and are equivalent to one-half (50%)50% of the difference between the first and second tier thresholds. Congressional Research Service 2 Social Security: Calculation and History of Taxing Benefits annual Social Security benefits—the average in December 2012 for a retired worker.6 The examples include other (non-Social Security) income of $20,000 or $30,000. Table 2. Example of Calculation of Social Security Benefits for Average Social Security Recipient and Different Assumptions about Other Income Step 1: Calculate Provisional Income John Mary Other income $20,000 $30,000 + 50% of Social Security (assume Social Security benefits are $15,139) $7,570 $7,570 = Provisional income $27,570 $37,570 $25,000 $25,000 $2,570 $9,000a $1,285 $4,500 $34,000 $34,000 $0 $3,570 $0 $3,034 Step 2: Compare Provisional Income to 1st Tier Threshold First tier threshold Calculate Excess over First Tier Threshold 6 The average monthly Social Security payment for a retired worker in November 2013 was $1,273.91. This would be an annual payment amount of $15,287. Information on current monthly benefit payments is available in the Monthly Statistical Snapshot at http://www.ssa.gov/policy/docs/quickfacts/stat_snapshot/. Congressional Research Service 2 Social Security: Calculation and History of Taxing Benefits Table 2. Example of Calculation of Taxable Social Security Benefits for Single Social Security Recipients with a $15,000 Benefit and Different Levels of Other Income Step 1: Calculate Provisional Income Other income + 50% of Social Security (assume Social Security benefits are $15,000) = Provisional income John Mary $20,000 $30,000 $7,500 $7,500 $27,500 $37,500 $25,000 $25,000 $2,500 $9,000 $1,250 $4,500 a $34,000 $34,000 $0 $3,500 $0 $2,975 $1,250 $7,475 Step 2: Compare Provisional Income to First Tier Threshold First tier threshold Excess over first tier threshold Lesser of • Provisional income minus first tier threshold or • Difference between first and second tier thresholds [$9,000] First tier taxable benefits Equalsequals Lesser of • 50% of Social Security or tier I benefits or • 50% of excess over first tier Step 3: Compare Prov.Provisional Income To 2ndSecond Tier Threshold Second tier threshold Calculate Excessexcess over second tier • Provisional income minus second tier threshold Second tier taxable benefits 85% of excess Step 4: Calculate Total Taxable Social Security Benefits If provisionalFor John: Provisional income is less than $34,000, so total taxable benefits equal first tier taxable benefits. $1,026 $7,095 If provisional For Mary: Provisional income is greater than $34,000, so total taxable benefits equal the lesser of • 85% of Social Security benefits (=$12,868750) or • First tier taxable benefits plus second tier taxable benefits Source: Table prepared by the ($4,500 + $2,975=$7,475) Source: Congressional Research Service (CRS). a. The maximum amount of First Tierfirst tier taxable benefits is 50% of the difference between the Second and First Tier thresholds ($34,000-$25,000=$9,000*50%=$4,500) Figure 1 shows taxable Social Security benefits for a single retiree with Social Security benefits of 15,139 as non-Social Security income (and provisional income) increases. Shown on the figure is the point at which taxable benefits are calculated using the Tier 2 formula in which the 6 The average monthly OASI payment for a retired worker in December 2012 was $1,261.61. This would be an annual payment amount of $15,139. Information on current monthly benefit payments is available by accessing beneficiary databases at http://www.ssa.gov/OACT/ProgData/icp.html. Congressional Research Service 3 Social Security: Calculation and History of Taxing Benefits comparisons in the formula use a ratio of 85% (rather than the 50% ratio for Tier 1). At this point, each additional dollar of non-Social Security income results in a larger increase in taxable Social Security benefits (because of the ratio change from 50% to 85% in the calculations). In Figure 1, the taxable Social Security benefits reach a maximum of 85% of Social Security benefits (illustrated by a flattening of the line) when non-Social Security income equals $34,000 in this example. Figure 1. Taxable Social Security Benefits as Non-Social Security (and Provisional) Income Increases for a Single Retiree with $15,139 in Annual Social Security Benefits, Tax Year 2012 Source: Figure prepared by the Congressional Research Service (CRS). The calculation of taxable Social Security benefits depends on the level of benefits, the tax filing status, and non-Social Security income. Holding non-Social Security income constant, as benefits increase, taxable Social Security benefits will increase. For the same levels of non-Social Security income and Social Security benefits, a married couple will have lower taxable Social Security benefits than a single retiree. Consequently, Figure 1 does not reflect other levels of benefits, or the impact of taxation on a married couple filing a joint tax return. Special Considerations There are special considerations in which the application of the taxation of benefits formula may vary. These include lump sum distributions, repayments, coordination of workers compensation, Congressional Research Service 4 Social Security: Calculation and History of Taxing Benefits treatment of non-residential aliens, and withholding from wages. Each of these issues is discussed in more detail in the Appendix to this report. State Taxation Although the Railroad Retirement Act prohibits states from taxing railroad retirement benefits (including any federally taxable Tier I benefits), states may tax Social Security benefits. In general, state personal income taxes follow federal taxes. That is, many states use as a beginning point for the state income tax calculations either federal adjusted gross income, federal taxable income, or federal taxes paid. All of these beginning points include the federally taxed portion of Social Security benefits. States with these beginning points for state taxation must then make an adjustment, or subtraction from income (or taxes), for railroad retirement benefits. A state may also make an adjustment for all or part or the federally taxed Social Security benefits. Some states do not begin the calculation of state income taxes with these federal tax values, but instead begin with a calculation based on income by source. The state may then include part or all of Social Security benefits7 in the state calculation of income. In tax year 2011, 30 of the states (and the District of Columbia) with a personal income tax fully excluded Social Security benefits from the state personal income tax. Fourteen states tax all, or part, of Social Security benefits, with 8 states following the federal taxation of Social Security benefits. Table 3 identifies what states fall into each of these categories for tax year 2011. Table 3. State Income Taxation of Social Security Benefits,Tax Year 2011 States taxing all or part of Social Security benefits, but not the same as federal taxation Colorado, Connecticut, Iowa, Kansas, Missouri, Montana States following federal taxation of Social Security benefits Minnesota, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, West Virginia Source: Rick Olin, Wisconsin Legislative Fiscal Bureau, Individual Tax Provisions in the States, July, 2012, available at http://legis.wisconsin.gov/lfb/publications/Miscellaneous/Documents/ 2012_07_25Individual%20Income%20Tax%20Provisions%20in%20the%20States.pdf. Because the income thresholds to determine the taxation of Social Security benefits are not indexed for inflation or wage growth, the share of beneficiaries affected by these thresholds is increasing over time. According to the Congressional Budget Office (CBO), 39% of (or 16.9 million) Social Security beneficiaries were affected by the income taxation of Social Security benefits in 2005. This compares with 32% of Social Security beneficiaries affected by taxation of benefits in 2000 and 26% in 1998.8 Table 4 shows the CBO estimates, under 2005 law and income levels, of the number of Social Security beneficiaries, the number of beneficiaries affected by the taxation of Social Security benefits, and the percentage of beneficiaries affected by taxation by level of income (cash income for the tax unit plus capital gains realizations). As shown in Table 4, the percentage of Social Security beneficiaries affected increases with the income level, with more than 90% of 7 States that chose to tax Social Security benefits, generally tax up to the federally taxed amount. CBO estimates are reported in the Green Book, Committee on Ways and Means, U.S. House of Representatives (1998, 2000, and 2008 editions). Changes from year to year may also reflect changes to CBO’s methodology and data sources over time. 8 Congressional Research Service 5 Social Security: Calculation and History of Taxing Benefits beneficiaries with an income of $40,000 or more affected by the taxation of Social Security benefits. Table 4. Number and Percentage of Beneficiaries with Taxable Social Security Benefits by Income Class Under 2005 Law and Income Levels Number of Social Security Beneficiaries (in thousands) Number of Beneficiaries Affected by Taxation (in thousands) Percentage of Beneficiaries Affected by Taxation Less than $10,000 5,957 0 0.0% $10,000 - $15,000 5,201 4 0.1% $15,000 - $20,000 3,688 12 0.3% $20,000 - $25,000 3,347 11 0.3% $25,000 - $30,000 2,917 76 2.6% $30,000 - $40,000 5,260 1,478 28.1% $40,000 - $50,000 4,497 3,168 70.4% $50,000 - $100,000 8,931 8,578 96.0% Over $100,000 3,632 3,607 99.3% Total 43,429 16,934 39.0% Level of Income Source: Congressional Budget Office simulations based on data from the Statistics of Income and supplemented by data from the Current Population Survey. Notes: Income is defined as AGI plus statutory adjustments, tax-exempt interest, and nontaxable Social Security benefits. Number of Social Security beneficiaries includes beneficiaries under and over age 65. As previously noted, because of the thresholds not all Social Security benefits are taxable. Figure 2 shows how Social Security benefits impact taxable income for a given level of Social Security benefits ($15,139) for a single retiree in tax year 2012.9 As non-Social Security income increases, more of Social Security benefits become taxable. This leads to an increase in overall taxable income. Because the taxation of Social Security benefits is capped at 85% in the second tier, the darkly shaded area in Figure 2 shows that the amount of Social Security benefits that are taxed remains constant as non-Social Security income increases beyond the second threshold. 9 All tax calculations for this report are estimated by CRS. The taxpayer is assumed to have used the standard deduction, including the additional amount for the elderly and disabled. Congressional Research Service 6 Social Security: Calculation and History of Taxing Benefits Figure 2. Taxable Income for an Average Single Retiree (Tax Year 2012) Source: Figure prepared by the Congressional Research Service (CRS). Figure 3 shows how different levels of Social Security benefits affect taxable income for a single retiree with either $20,000 or $30,000 in non-Social Security income.10 In Figure 3, the Social Security benefits increase until they reach the annual maximum benefits for a person receiving benefits at the age of 66 in 2012—$30,156. 10 Ibid. Congressional Research Service 7 Social Security: Calculation and History of Taxing Benefits Figure 3. Taxable Income for a Single Retiree with $20,000 or $30,000 in Non-Social Security Income as Annual Social Security Benefits Increase, Tax Year 2012 Source: Figure prepared by the Congressional Research Service (CRS). Note: Assumes Social Security benefits increase to $30,156the maximum benefit in 2012 for a person retiring in 2012 at the age of 66. Table 5 shows the impact of rising income on the share of benefits that are taxed for the U.S. taxpayers in 2005. Level of income includes cash income plus capital gains realizations. As shown in Table 5, as income increases, taxes as a percent of Social Security benefits rises. Congressional Research Service 8 Social Security: Calculation and History of Taxing Benefits Table 5. Social Security Benefits and Taxes on Social Security Benefits by Income Class Under 2005 Law and Income Levels Level of Income Social Security Benefits (in millions) Taxes on Social Security Benefits (in millions) Taxes as a Percentage of Benefits Less than $10,000 $40,403 $0 0.0% $10,000 - $15,000 $53,769 $1 0.0% $15,000 - $20,000 $40,480 $4 0.0% $20,000 - $25,000 $36,927 $9 0.0% $25,000 - $30,000 $33,009 $17 0.1% $30,000 - $40,000 $59,893 $390 0.7% $40,000 - $50,000 $51,717 $1,412 2.7% $50,000 - $100,000 $110,421 $11,508 10.4% Over $100,000 $49,378 $10,767 21.8% Total $475,997 $24,107 5.1% Source: Congressional Budget Office simulations based on data from the Statistics of Income and supplemented by data from the Current Population Survey. Notes: Income is defined as AGI plus statutory adjustments, tax-exempt interest, and nontaxable Social Security benefits. Number of Social Security beneficiaries includes beneficiaries under and over age 65. Impact on the Trust Funds The proceeds from taxing Social Security and Tier I benefits at the 50% rate are credited to the Old-Age and Survivors Insurance (OASI) trust fund, the Disability Insurance (DI) trust fund and the Railroad Retirement system respectively, on the basis of the source of the benefits taxed. Proceeds from taxing Social Security benefits and Tier I benefits at the 85% rate are credited to the Hospital Insurance trust fund (HI) of Medicare. The Trustees Report reported income to OASDI of $23.8 billion in 2011 from the taxation of benefits, or 3.0% of the combined income for both funds.11 Income from the taxation of benefits in the HI fund in 2011 was $15.1 billion, or 2.8% of total HI fund income.12 History of Taxing Social Security Benefits Until 1984, Social Security benefits were exempt from the federal income tax. The exclusion was based on rulings made in 1938 and 1941 by the Department of the Treasury, Bureau of Internal Revenue (the predecessor of the Internal Revenue Service). The 1941 Bureau ruling on OASDI 11 Social Security Administration, 2012 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, Apr. 25, 2012, available at http://www.ssa.gov/OACT/TR/2012. Of the $23.8 billion total for OASDI, $22.2 billion went to the OASI trust fund and $1.6 billion went to the DI trust fund. 12 Center for Medicare and Medicaid Services, 2012 Annual Report of the Board of Trustees of the Federal Hospital Insurance Trust and Federal Supplementary Medical Insurance Trust Funds, Apr. 25, 2012, available at http://www.cms.hhs.gov/ReportsTrustFunds/downloads/tr2012.pdf. Congressional Research Service 9 Social Security: Calculation and History of Taxing Benefits payments viewed benefits as being for general welfare and reasoned that subjecting the payments to income taxation would be contrary to the purposes of Social Security.13 Under these rules, the treatment of Social Security benefits was similar to that of certain types of government transfer payments (such as Aid to Families with Dependent Children, Supplemental Security Income, and black lung benefits). This was in sharp contrast to then-current rules for retirement benefits under private pension plans, the Federal Civil Service Retirement System (CSRS), and other government pension systems. Benefits from these other pension plans were fully taxable, except for the portion of total lifetime benefits (using projected life expectancy) attributable to the employee’s own contributions to the system (and on which he or she had already paid income tax). Currently (and as in 1941), under Social Security the worker’s contribution to the system is his or her share (one-half (50%)) of the payroll tax, officially known as the Federal Insurance Contributions Act (FICA) tax. The amount the worker pays into the Social Security system in FICA taxes is not subtracted to determine income subject to the federal income tax, and is therefore taxed. The employer’s contributions to the system are not considered part of the employee’s gross income, and are deductible from the employer’s business income as a business expense. Consequently, neither the employee nor the employer pays taxes on the employer’s contribution. The 1979 Advisory Council on Social Security concluded that the 1941 ruling was wrong and that the tax treatment of private pensions was a more appropriate model for tax treatment of Social Security benefits.14 The council estimated that the most anyone who entered the workforce in 1979 would pay in payroll taxes during his or her lifetime would equal 17% of the Social Security benefits he or she would ultimately receive. (This was the most any individual would pay; in the aggregate, workers would make payroll tax payments amounting to substantially less than 17% of their ultimate benefits.) Because of the administrative difficulties involved in determining the taxable amount of each individual benefit, the council recommended instead that half of everyone’s benefit be taxed. They justified this ratio as a matter of “rough justice” and noted that it coincided with the portion of the tax (the employer’s share) on which income taxes had not been paid. This position to tax Social Security benefits was in contrast to the position of the National Commission on Social Security, established by Congress in the Social Security Amendments of 1977 (P.L. 95-216). The commission did not, in its 1981 final report, include a recommendation to tax Social Security benefits. The National Commission on Social Security Reform (often referred to as the “Greenspan Commission”), appointed by President Reagan in 1981, recommended in its 1983 report15 that, beginning in 1984, one-half (50%) of Social Security cash benefits and Tier I benefits payable under the Railroad Retirement Act be taxable for individuals whose adjusted gross income, excluding Social Security cash benefits, exceeded certain thresholds—$20,000 for a single taxpayer, and $25,000 for a married couple, with the proceeds of such taxation credited to the 13 U.S. Congress, Senate Committee on Finance, Tax Free Status of Social Security Benefits, Report to Accompany S.Res. 87, Comm. Rep. No. 97-135, June 15, 1981. 14 U.S. Congress, Select Committee on Aging, Hearings Before the Committee on Retirement Income And Employment, Oversight on Recommendations of the 1979 Social Security Advisory Council, Statement of Henry Aaron, Chairman of the Advisory Council on Social Security, Comm. Pub. No. 96-230, March 11 and 13, 1980, p. 13. 15 Social Security Administration, Report of the National Commission on Social Security Reform, January 1983, pp. 210 through 2-11, available at http://www.ssa.gov/history/reports/gspan.html. Congressional Research Service 10 Social Security: Calculation and History of Taxing Benefits Social Security trust funds. The commission did not include any provisions for indexing the threshold amounts. The commission estimated that 10% of OASDI recipients would be subject to taxation of benefits. The commission acknowledged that the proposal had a “notch” problem, in that the extra dollar of income that would put one over the threshold would have had the effect of subjecting fully one-half (50%) of Social Security benefits to taxation, but trusted that it would be rectified during the legislative process. In enacting the 1983 Social Security Amendments (P.L. 98-21), Congress adopted the commission’s recommendation to tax Social Security benefits, but with a formula for determining taxable benefits that gradually increased as a person’s income rose above the thresholds, up to a maximum of one-half (50%) of benefits. The formula calculated taxable benefits as the lesser of one-half (50%) of benefits or one-half (50%) of the excess of the taxpayer’s provisional income over thresholds of $25,000 (single) and $32,000 (married couple). Provisional income was defined as total income plus certain tax-exempt income (tax-exempt interest) plus certain income exclusions plus one-half (50%) of Social Security benefits. At the same time, the tax credit for the elderly and disabled was expanded to provide additional tax relief for lower income elderly taxpayers.16 In 1993, the Social Security Administration’s Office of the Actuary estimated that, if pension tax rules were applied to Social Security, the ratio of total employee Social Security payroll taxes to expected benefits for current recipients (in 1993) would be approximately 4% or 5%. The actuarial estimates were that for workers just entering the workforce,17 the ratio would be, on average, about 7%. Because Social Security benefits replaced a higher proportion of earnings of workers who were lower paid and had dependents, and because women had longer life expectancies, the workers with the highest ratio of taxes to benefits would be single, highly paid males. The estimated ratio for these workers (highly paid males) entering the workforce in 1993 was 15%. Applying the tax rules for private and public pensions presents practical administrative problems. Determining the proper exclusion would be complex for several reasons, including calculating the ratio of contributions to benefits for each individual worker’s account when, unlike private pensions, several people may receive benefits on the basis of the same worker’s account. President Clinton proposed (as part of his FY1994 budget proposal) that the portion of Social Security benefits subject to taxation be increased from 50% to 85%, effective in tax year 1994. As under then-current law, only Social Security recipients whose provisional income exceeded the thresholds of $25,000 (single) and $32,000 (married couple) were to pay taxes on their benefits. Also as under then-current law, the first step was to add one-half (50%), not 85%, of benefits to total income. Because the thresholds and definition of provisional income did not change, the measure would only affect recipients already paying taxes on benefits. However, the ratio used to compute the amount of taxable benefits was increased from 50% to 85%. Taxing no more than 85% of Social Security benefits (the portion not based on contributions by a recipient, including highly paid males) would ensure that no one would have a higher percentage of Social Security 16 The credit was originally created to provide a benefit to retirees that had taxable retirement income rather than nontaxable Social Security benefits. 17 The average for all workers entering the work force is for all workers born in 1970 entering the workforce. The estimate for single males assumed the worker entering the work force in 1993 was 22 years old with steady income until retirement at either age 62 or the normal retirement age. Congressional Research Service 11 Social Security: Calculation and History of Taxing Benefits benefits subject to tax than if the tax treatment of private and civil service pensions were actually applied. The proceeds from the increase (from 50% to 85%) were slated to be credited to the Medicare Hospital Insurance program, which had a less favorable financial outlook than Social Security at that time. Doing so also avoided possible procedural obstacles (budget points of order that can be raised regarding changes to the Social Security program in the budget reconciliation process). This measure was included in the 1993 Omnibus Budget Reconciliation Act (OBRA), which passed the House on May 27, 1993. The Senate version of the bill included a provision to tax Social Security benefits up to 85% but imposed it only after provisional income exceeded new thresholds of $32,000 (single) and $40,000 (married couple). When the House and Senate versions of the budget package were negotiated in conference, the conference agreement adopted the Senate version of the taxation of Social Security benefits provision and raised the thresholds to $34,000 (single) and $44,000 (married couple). President Clinton signed the measure into law (as part of P.L. 103-66) on August 10, 1993. Congressional Research Service 12 Social Security: Calculation and History of Taxing Benefits Appendix. Special Considerations Under Taxation of Benefits Lump Sum Distributions A Social Security beneficiary may receive a lump sum distribution of benefits for one or more prior years.18 In this situation, a beneficiary has the option of choosing between two methods for calculating the taxable portion of the benefits for prior years: (1) the taxpayer may include all of the benefits for prior years in calculating the taxable benefits for the current year; or (2) the taxpayer may re-calculate the prior year taxable benefits using prior year income and take the difference between the recalculated taxable benefits and the taxable benefits reported in each prior year. In computing the taxable portion of benefits in prior years, the provisional income for the prior years is adjusted gross income plus tax exempt interest plus the excluded income (as detailed earlier) plus the addition (or add-back) of the adjustment for student loan interest, plus one-half (50%) of Social Security benefits. Repayments Sometimes a Social Security beneficiary must repay a prior overpayment of benefits. In this case, the calculation of taxable Social Security benefits is based on the net benefits—gross benefits less the repayment. Married taxpayers filing a joint tax return would use the total of the net Social Security benefits for the tax year received by each party (taxpayer plus spouse). If, however, the repayment results in negative net Social Security benefits, there are two consequences for taxes: (1) there are no taxable Social Security benefits; and (2) the taxpayer may take a miscellaneous deduction19 as part of itemized deductions, or a credit for the negative net Social Security benefits. If the negative net Social Security benefits are less than $3,000, the taxpayer must include negative net Social Security benefits in miscellaneous deductions for computing itemized deductions. If the negative net Social Security benefits are greater than $3,000, the taxpayer must compute the current year tax liability two ways: (1) using the negative balance as a miscellaneous deduction for computing itemized deductions; and (2) re-computing the taxes (without the overpayment income) for the prior years in which an overpayment was received and subtracting these amounts from the prior year taxes paid, and then subtracting this result (the sum of the differences in prior year taxes) from the current year tax liability. If the tax liability computed using the negative balance as a miscellaneous deduction is lower, the taxpayer claims the deduction. If the tax liability from re-computing prior year’s taxes is lower, the taxpayer claims a tax credit equal to the sum of the prior year tax differences. 18 This is not the lump-sum death benefit which is not subject to the federal income tax. An individual originally denied benefits, but approved on appeal, may receive a lump sum amount for the period when benefits were denied (which may be prior years). 19 Miscellaneous itemized deductions are subject to a 2% floor. That is, they are included in itemized deductions to the extent they exceed 2% of adjusted gross income. Congressional Research Service 13 Social Security: Calculation and History of Taxing Benefits Coordination of Workers Compensation Under current law, an individual’s Social Security benefits (until the full retirement age), may be reduced by a portion of the Workers Compensation payments (payments from some other public disability program) received by the individual. Any reduction in Social Security benefits due to the receipt of Workers Compensation is considered to be a Social Security benefit and is used in determining the amount of Social Security benefits subject to taxation. Treatment of Nonresident Aliens Citizenship is not required for receipt of Social Security benefits. Aliens may receive benefits provided they have engaged in covered employment and otherwise meet eligibility requirements. In general, 85% of the Social Security benefits for nonresident aliens is subject to income tax (i.e., none of the thresholds apply). However, there are a number of exceptions to this general rule on the basis of tax treaties such that nonresident aliens or U.S. citizens living abroad may not have U.S. Social Security benefits subject to U.S. income taxes.20 Withholding In general, withholding for a wage earner is based on the estimated income taxes for a full year of earnings at the periodic (weekly, bi-weekly, monthly, etc.) rate. Taxable Social Security benefits, and the associated taxes, are based on the amount of non-Social Security income earned by a recipient during the tax year. The Social Security Administration, without knowledge about the amount of other income received by a beneficiary, is unable to properly determine the amount of taxes that should be withheld from Social Security benefits. Like other non-wage earners, Social Security recipients can make quarterly estimated income tax payments. The Uruguay Round Agreements Act (P.L. 103-465) amended the Internal Revenue Code (IRC) to allow individuals to request that monies be withheld from certain federal payments to satisfy their income tax liability (this is commonly referred to as voluntary tax withholding). An amendment to Section 207 of the Social Security Act allowed this voluntary tax withholding from Social Security benefits.21 Voluntary tax withholding became effective with payments issued in February 1999. The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) permitted voluntary withholding from Social Security benefits at rates of 7%, and equal to the bottom three tax bracket tax rates (currently 10%, 15%, and 25%). The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended the EGTRRA provisions to tax year 2012. The American Taxpayer Relief Act of 2012 (ATRA; P.L. 112-240) made the EGTRRA provisions permanent. Aliens residing outside the United States are subject to different tax withholding rules. Section 871 of the Internal Revenue Code imposes an arbitrary rate of tax withholding (30%) on almost all of the U.S. income of nonresident aliens, unless a lower rate is fixed by treaty. Thus, 30% of 20 Internal Revenue Service, Publication 915 provides a list of the countries whose citizens (as nonresident aliens) are exempt from U.S. income taxes of Social Security benefits, and countries where residing U.S. citizens are exempt. 21 Because they are not subject to the federal income tax, Supplemental Security Income payments, Black Lung payments, Medicare premium refunds, Lump Sum Death Payments, returned check re-issuances, and benefits due before January 1984, are not subject to voluntary tax withholding. Congressional Research Service 14 Social Security: Calculation and History of Taxing Benefits 85% (or 25.5%) of a nonresident alien’s Social Security benefits may be withheld for federal income taxes. Author Contact Information Christine Scott Specialist in Social Policy cscott@crs.loc.gov, 7-7366second and first tier thresholds ($34,000-$25,000=$9,000*50%=$4,500) The calculation of taxable Social Security benefits depends on the level of benefits and the level of non-Social Security income. Holding benefits constant, as non-Social Security income increases, provisional income increases, and therefore the amount of taxable Social Security benefits increases. Holding non-Social Security income constant, as Social Security benefits increase, the amount of Social Security benefits that is taxable increases. Those two perspectives are illustrated in the two figures below. (The figures are for single retirees only, but they would be similar for married couples.) Congressional Research Service 3 Social Security: Calculation and History of Taxing Benefits Figure 1 shows taxable Social Security benefits for single retirees with four different amounts of annual Social Security benefits ($10,000, $15,000, $20,000, and $25,000) as non-Social Security income increases from zero to $45,000. (Provisional income, which equals non-Social Security income plus half of Social Security benefits, is not shown directly in the figure.) Once provisional income exceeds the first tier threshold of $25,000, each additional dollar of non-Social Security income results in 50 cents of additional taxable income. For example, for someone with Social Security benefits of $10,000, no benefits are taxable unless non-Social Security income exceeds $20,000, in which case provisional income would exceed $25,000 (which equals $20,000 plus half of $10,000). Once provisional income exceeds the second tier threshold, each additional dollar of non-Social Security income results in an additional 85 cents of taxable income. As described above, the second tier threshold occurs when provisional income exceeds $34,000, at which point taxable Social Security benefits exceed $4,500. In the figure, a horizontal line marks $4,500 of taxable Social Security benefits. The amount of Social Security benefits that are taxable continues to increase as non-Social Security income increases until 85% of Social Security benefits are taxable. After that, the amount of taxable benefits is constant, as shown by the flat portions of the lines on the right-hand side of the figure. Note that the additional tax owed is less than the additional taxable income. The additional tax owed equals the additional taxable income multiplied by the taxpayer’s marginal tax rate. Congressional Research Service 4 Social Security: Calculation and History of Taxing Benefits Figure 1. Taxable Social Security Benefits as Annual Non-Social Security Income Increases For Single Retirees with Different Amounts of Annual Social Security Benefits Taxable Social Security Benefits $25,000 After 85% of benefits are taxable, no further increase in taxable benefits (flat lines) $20,000 Social Security Benefits of $25,000 $15,000 Social Security Benefits of $20,000 $10,000 Social Security Benefits of $15,000 Social Security Benefits of $10,000 In second tier, 85% rate applies (steeper lines) $5,000 $4,500 of taxable benefits In first tier, 50% rate applies (less steep lines) $0 $0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000 $45,000 Taxable Non-Social Security Income Source: Congressional Research Service (CRS). Note: Once provisional income (taxable non-Social Security income plus half of Social Security benefits) exceeds the first tier threshold of $25,000, each additional dollar of non-Social Security income results in 50 cents of additional taxable income. Once provisional income exceeds the second tier threshold of $34,000, when taxable Social Security benefits equal $4,500, each additional dollar of non-Social Security income results in 85 cents of additional taxable income, reflected in the steeper lines. Figure 2 shows taxable Social Security benefits for single retirees with three different levels of non-Social Security income ($20,000, $30,000, and $40,000) as Social Security benefits increase. (Provisional income, which equals non-Social Security income plus half of Social Security benefits, is not shown directly in the figure.) For people with $10,000 of Social Security benefits, those benefits would be untaxed unless non-Social Security income exceeded $20,000, at which point provisional income would exceed the $25,000 threshold (which equals half of $10,000 plus $20,000). Depending on the amount of non-Social Security income, the amount of Social Security benefits that is taxable increases at varying rates as total benefits increase, according to the taxation of benefit rules described above. As noted above, the additional tax owed is less than the additional taxable income, because the additional tax owed equals the additional taxable income multiplied by the taxpayer’s marginal tax rate. Congressional Research Service 5 Social Security: Calculation and History of Taxing Benefits Figure 2.Taxable Social Security Benefits as Total Annual Social Security Benefits Increase For Single Retirees with Different Amounts of Annual Non-Social Security Income Taxable Social Security Benefits $25,000 $20,000 With $40,000 of Non-Social Security Income $15,000 $10,000 With $30,000 of Non-Social Security Income $5,000 With $20,000 of Non-Social Security Income $0 $0 $2,500 $5,000 $7,500 $10,000 $12,500 $15,000 $17,500 $20,000 $22,500 $25,000 $27,500 $30,000 Total Social Security Benefits Source: Congressional Research Service (CRS). Notes: For any fixed amount of non-Social Security income, the amount of taxable Social Security benefits increases as total Social Security benefits increase. The slope of the lines vary because the amount of Social Security benefits that is taxable increases at varying rates as total benefits increase. For the same levels of non-Social Security income and Social Security benefits, a married couple will have lower taxable Social Security benefits than a single retiree. Consequently, Figures 1 and 2 do not reflect the impact of taxation on a married couple filing a joint tax return. Special Considerations There are special considerations in which the application of the taxation of benefits formula may vary. These include lump sum distributions, repayments, coordination of workers’ compensation, treatment of nonresident aliens, and withholding from wages. Each of these issues is discussed in more detail in the Appendix to this report. State Taxation Although the Railroad Retirement Act prohibits states from taxing railroad retirement benefits, including any federally taxable Tier I benefits (45 U.S.C. §231m), states may tax Social Security benefits. In general, state personal income taxes follow federal taxes. That is, many states use as a Congressional Research Service 6 Social Security: Calculation and History of Taxing Benefits beginning point for the state income tax calculations either federal adjusted gross income, federal taxable income, or federal taxes paid. All of these beginning points include the federally taxed portion of Social Security benefits. States with these beginning points for state taxation must then make an adjustment, or subtraction from income (or taxes), for railroad retirement benefits. A state may also make an adjustment for all or part or the federally taxed Social Security benefits. Some states do not begin the calculation of state income taxes with these federal tax values but instead begin with a calculation based on income by source. The state may then include part or all of Social Security benefits7 in the state calculation of income. As shown in Table 3, 30 states and the District of Columbia fully excluded Social Security benefits from the state personal income tax. Six states tax all or part of Social Security benefits but differ from the federal government, and seven states follow the federal government in their tax treatment of Social Security benefits. The remaining seven states have no personal income tax. Table 3. State Income Taxation of Social Security Benefits,Tax Year 2014 Thirty states and the District of Columbia exempt Social Security benefits from income taxation Alabama, Arizona, Arkansas, California, Delaware, District of Columbia, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, Tennessee, Virginia, Wisconsin Six states tax all or part of Social Security benefits, but not the same as federal taxation Colorado, Connecticut, Kansas, Missouri, Montana, Utah Seven states follow federal taxation of Social Security benefits Minnesota, Nebraska, New Mexico, North Dakota, Rhode Island, Vermont, West Virginia States without an income tax Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming Source: Rick Olin, Wisconsin Legislative Fiscal Bureau, Individual Tax Provisions in the States, Informational Paper 4, January 2013, available at http://legis.wisconsin.gov/lfb/publications/Informational-Papers/Documents/2013/ 4_Individual%20Income%20Tax%20Provisions%20in%20the%20States.pdf . Note: Before 2014, Iowa taxed some Social Security benefits. Taxation of Social Security Benefits by Income Level Because the income thresholds to determine the taxation of Social Security benefits are not indexed for inflation or wage growth, the share of beneficiaries affected by these thresholds increases over time. According to the Congressional Budget Office (CBO), 39% of Social Security beneficiaries (16.9 million people) were affected by the income taxation of Social Security benefits in 2005, the most recent year for which the analysis is available. That share was lower in earlier years: 32% of beneficiaries were affected by taxation of benefits in 2000 and 26% were affected in 1998.8 7 States that chose to tax Social Security benefits generally tax up to the federally taxed amount. Estimates provided by CBO for other years were originally reported in the Green Book, Committee on Ways and Means, U.S. House of Representatives (1998, 2000, and 2008 editions). Changes from year to year may also reflect changes to CBO’s methodology and data sources over time. 8 Congressional Research Service 7 Social Security: Calculation and History of Taxing Benefits The number of tax returns with taxable Social Security benefits has increased substantially since 2005. In 2011, the most recent year for which data are available, 16.8 million returns reported taxable benefits. That was 32% more than in 2005, when there were 12.7 million returns with taxable Social Security benefits.9 (The number of returns does not match the number of individual beneficiaries because many returns include married couples.) Table 4 shows CBO’s estimates, under 2005 law and income levels, of the number of Social Security beneficiaries and of the number and share of beneficiaries affected by the taxation of Social Security benefits, by level of income (cash income for the tax unit plus capital gains realizations). As shown in Table 4, the percentage of Social Security beneficiaries affected increases with income. Less than 1% of beneficiaries with income under $30,000 had taxable Social Security benefits, but more than 90% of those with income of $40,000 or more paid taxes on their benefits. Table 4. Number and Percentage of Beneficiaries with Taxable Social Security Benefits by Income Class Under 2005 Law and Income Levels Number of Social Security Beneficiaries (thousands) Number of Beneficiaries Affected by Taxation (thousands) Percentage of Beneficiaries Affected by Taxation Less than $10,000 5,957 0 0.0% $10,000 - $15,000 5,201 4 0.1% $15,000 - $20,000 3,688 12 0.3% $20,000 - $25,000 3,347 11 0.3% $25,000 - $30,000 2,917 76 2.6% $30,000 - $40,000 5,260 1,478 28.1% $40,000 - $50,000 4,497 3,168 70.4% $50,000 - $100,000 8,931 8,578 96.0% Over $100,000 3,632 3,607 99.3% 43,429 16,934 39.0% Income Class Total Source: Congressional Budget Office simulations based on Statistics of Income data from the Internal Revenue Service, supplemented by data from the Current Population Survey. Notes: Income is defined as adjusted gross income plus statutory adjustments, tax-exempt interest, and nontaxable Social Security benefits. Number of Social Security beneficiaries includes beneficiaries under and over the age of 65. Table 5 shows the impact of rising income on the share of benefits that are taxed for the U.S. taxpayers in 2005. Income includes cash income plus capital gains realizations. As shown in Table 5, as income increases, taxes as a percentage of Social Security benefits rises. 9 Internal Revenue Service, “SOI [Statistics of Income] Tax Stats - Individual Statistical Tables by Size of Adjusted Gross Income,” Table 1.4: All Returns: Sources of Income, Adjustments, and Tax Items, available at http://www.irs.gov/uac/SOI-Tax-Stats—Individual-Statistical-Tables-by-Size-of-Adjusted-Gross-Income. Congressional Research Service 8 Social Security: Calculation and History of Taxing Benefits Table 5. Social Security Benefits and Taxes on Social Security Benefits by Income Class Under 2005 Law and Income Levels Social Security Benefits (in millions) Taxes on Social Security Benefits (in millions) Taxes as a Percentage of Benefits Less than $10,000 $40,403 $0 0.0% $10,000 - $15,000 $53,769 $1 0.0% $15,000 - $20,000 $40,480 $4 0.0% $20,000 - $25,000 $36,927 $9 0.0% $25,000 - $30,000 $33,009 $17 0.1% $30,000 - $40,000 $59,893 $390 0.7% $40,000 - $50,000 $51,717 $1,412 2.7% $50,000 - $100,000 $110,421 $11,508 10.4% Over $100,000 $49,378 $10,767 21.8% $475,997 $24,107 5.1% Income Class Total Source: Congressional Budget Office simulations based on Statistics of Income data from the Internal Revenue Service, supplemented by data from the Current Population Survey. Notes: Income is defined as adjusted gross income plus statutory adjustments, tax-exempt interest, and nontaxable Social Security benefits. Number of Social Security beneficiaries includes beneficiaries under and over the age of 65. Impact on the Trust Funds The proceeds from taxing Social Security and Railroad Retirement benefits at the 50% rate are credited to the Social Security’s two trust funds—the Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI) trust funds—and to the Railroad Retirement system, on the basis of the source of the benefits taxed. Proceeds from taxing benefits at higher rates are credited to Medicare’s Hospital Insurance (HI) trust fund. In 2013, the OASI and DI trust funds were credited with $21.1 billion from taxation of benefits, or 2.5% of the funds’ total income.10 Income from the taxation of benefits in the HI fund in 2013 was $14.3 billion, or 5.7% of total HI fund income.11 Because the income thresholds used to determine the share of benefits that is taxable are not indexed for inflation or wage growth, income taxes on benefits will become an increasingly important source of tax revenues for Social Security and Medicare. The Social Security and Medicare trustees project that over the next 75 years, income taxes will grow from 4% of total Social Security tax revenue to 7%.12 For Medicare, they are projected to increase from 7% to 13% 10 Social Security Administration, Trust Fund Financial Data, http://www.ssa.gov/OACT/ProgData/allOps.html. Of the $21.1 billion, $20.7 billion was credited to the OASI trust fund and $0.4 billion to the DI trust fund. 11 Congressional Research Service calculation based on Department of the Treasury, Monthly Reports of the Hospital Insurance Trust Fund, at http://www.treasurydirect.gov/govt/reports/tfmp/hospins/hospins.htm. 12 Social Security Administration, Office of the Chief Actuary, “Components of Annual Income Rates—2013 OASDI Trustees Report,” at http://www.ssa.gov/oact/TR/2013/lr4b10.html. Congressional Research Service 9 Social Security: Calculation and History of Taxing Benefits of total tax revenues.13 (The rest of Social Security and Medicare tax revenue comes from the payroll taxes for those programs.) Revenue from taxation of benefits will be a smaller share of total program revenues, because in addition to tax revenue, both programs receive interest on trust fund balances, and Medicare receives income from premiums and from general revenue. History of Taxing Social Security Benefits Until 1984, Social Security benefits were exempt from the federal income tax. The exclusion was based on rulings made in 1938 and 1941 by the Department of the Treasury, Bureau of Internal Revenue (the predecessor of the Internal Revenue Service). The 1941 Bureau ruling on Social Security payments viewed benefits as being for general welfare and reasoned that subjecting the payments to income taxation would be contrary to the purposes of Social Security.14 Under these rules, the treatment of Social Security benefits was similar to that of certain types of government transfer payments (such as Aid to Families with Dependent Children (AFDC), Supplemental Security Income (SSI), and benefits under the Black Lung Benefits Act). This was in sharp contrast to then-current rules for retirement benefits under private pension plans, the federal Civil Service Retirement System (CSRS), and other government pension systems.15 Benefits from those pension plans were fully taxable, except for the portion of total lifetime benefits (using projected life expectancy) attributable to the employee’s own contributions to the system (and on which he or she had already paid income tax). Currently (and as in 1941), under Social Security the worker’s contribution to the system is half of the payroll tax, officially known as the Federal Insurance Contributions Act (FICA) tax. The amount the worker pays into the Social Security system in FICA taxes is not subtracted to determine income subject to the federal income tax, and is therefore taxed. The employer’s contributions to the system are not considered part of the employee’s gross income, and are deductible from the employer’s business income as a business expense. Consequently, neither the employee nor the employer pays taxes on the employer’s contribution.16 The 1979 Advisory Council on Social Security concluded that because Social Security benefits are based on earnings in covered employment, the 1941 ruling was wrong and that the tax treatment of private pensions was a more appropriate model for tax treatment of Social Security benefits.17 The council estimated that the most anyone who entered the workforce in 1979 would 13 Center for Medicare and Medicaid Services, Office of the Actuary, “Medicare Sources of Income as a Percentage of Total Income,” in 2013 Expanded and Supplementary Tables to the 2012 Medicare Trustees Report, at http://www.cms.gov/Research-Statistics-Data-and-Systems/Statistics-Trends-and-Reports/ReportsTrustFunds/ index.html. 14 U.S. Congress, Senate Committee on Finance, Tax Free Status of Social Security Benefits, report to accompany S.Res. 87, S.Rept. 97-135, June 15, 1981. 15 Most federal civilian employees hired before 1984 are covered by CSRS; those hired later are covered by the Federal Employees’ Retirement System (FERS). See CRS Report 98-810, Federal Employees’ Retirement System: Benefits and Financing, by Katelin P. Isaacs. 16 Under the Self-Employment Contributions Act (SECA), self-employed workers pay the full 12.4% payroll tax, but to ensure parity with FICA, half of those payments are exempt from income tax. 17 U.S. Congress, Senate, Select Committee on Aging, Hearings Before the Committee on Retirement Income And Employment, Oversight on Recommendations of the 1979 Social Security Advisory Council, Statement of Henry Aaron, Chairman of the Advisory Council on Social Security, report. no. 96-230, March 11 and 13, 1980, p. 13. Congressional Research Service 10 Social Security: Calculation and History of Taxing Benefits pay in payroll taxes during his or her lifetime would equal 17% of the Social Security benefits he or she would ultimately receive. (This was the most any individual would pay; in the aggregate, workers would make payroll tax payments amounting to substantially less than 17% of their ultimate benefits.) Because of the administrative difficulties involved in determining the taxable amount of each individual benefit and to avoid “taxing more of the benefit than most people would consider appropriate,” the council recommended instead that half of everyone’s benefit be taxed. They justified this ratio as a matter of “rough justice” and noted that it coincided with the portion of the tax (the employer’s share) on which income taxes had not been paid.18 This position to tax Social Security benefits was in contrast to the position of the National Commission on Social Security, established by Congress in the Social Security Amendments of 1977 (P.L. 95216). The commission did not, in its 1981 final report, include a recommendation to tax Social Security benefits. The National Commission on Social Security Reform (often referred to as the “Greenspan Commission”), appointed by President Reagan in 1981, recommended in its 1983 report that, beginning in 1984, 50% of Social Security cash benefits and Railroad Retirement Tier I benefits be taxable for individuals whose adjusted gross income, excluding Social Security benefits, exceeded $20,000 for a single taxpayer and $25,000 for a married couple, with the proceeds of such taxation credited to the Social Security trust funds.19 The commission did not include any provisions for indexing the thresholds. The commission estimated that 10% of Social Security beneficiaries would be subject to taxation of benefits. The commission acknowledged that the proposal had a “notch” problem, in that people with income at the thresholds would pay significantly higher taxes than those with only one dollar less, but trusted that it would be rectified during the legislative process. In enacting the 1983 Social Security Amendments (P.L. 98-21), Congress adopted the commission’s recommendation to tax Social Security benefits, but with a formula that gradually increased the taxable share as a person’s income rose above the thresholds, up to a maximum of 50% of benefits. The formula calculated taxable benefits as the lesser of 50% of benefits or 50% of the excess of the taxpayer’s provisional income over thresholds of $25,000 (for single filers) and $32,000 (for married filers). Provisional income equaled adjusted gross income plus taxexempt interest plus certain income exclusions plus 50% of Social Security benefits. In 1993, the Social Security Administration’s Office of the Actuary estimated that, if pension tax rules were applied to Social Security, the ratio of total employee Social Security payroll taxes to expected benefits for current recipients (in 1993) would be approximately 4% or 5%. The actuarial estimates were that for workers just entering the workforce, the ratio would be, on average, about 7%.20 Because Social Security benefits replaced a higher proportion of earnings of workers who were lower paid and had dependents, and because women had longer life expectancies, the workers with the highest ratio of taxes to benefits would be single, highly paid males. The estimated ratio for these workers (highly paid males) entering the workforce in 1993 was 15%. 18 Social Security Administration, Social security financing and benefits, Report of the 1979 Advisory Council, 1981, pp.64-65. 19 Social Security Administration, Report of the National Commission on Social Security Reform, January 1983, pp. 210 through 2-11, available at http://www.ssa.gov/history/reports/gspan.html. 20 Unpublished memo from Steve Goss, Social Security Office of the Actuary, November 19, 1993. The ratios were computed using nominal dollar values for both taxes and benefits. Congressional Research Service 11 Social Security: Calculation and History of Taxing Benefits Applying the tax rules for private and public pensions presents practical administrative problems. Determining the proper exclusion would be complex for several reasons, including the difficulty of calculating the ratio of contributions to benefits for each individual when several people may receive benefits on the basis of the same worker’s account. President Clinton proposed (as part of his FY1994 budget proposal) that the portion of Social Security benefits subject to taxation be increased from 50% to 85%, effective in tax year 1994. As under then-current law, only Social Security recipients whose provisional income exceeded the thresholds of $25,000 (for single filers) and $32,000 (for married filers) were to pay taxes on their benefits. Also as under then-current law, the first step was to add 50%, not 85%, of benefits to adjusted gross income. Because the thresholds and definition of provisional income did not change, the measure would only affect recipients already paying taxes on benefits. However, the ratio used to compute the amount of taxable benefits was increased from 50% to 85%. Taxing no more than 85% of Social Security benefits (the estimated portion not based on contributions by a recipient, including highly paid males) would ensure that no one would have a higher percentage of Social Security benefits subject to tax than if the tax treatment of private and civil service pensions were actually applied. The proceeds from the increase (from 50% to 85%) were slated to be credited to the Medicare Hospital Insurance program, which had a less favorable financial outlook than Social Security. Doing so also avoided possible procedural obstacles (budget points of order that can be raised regarding changes to the Social Security program in the budget reconciliation process). This measure was included in the 1993 Omnibus Budget Reconciliation Act (OBRA), which passed the House on May 27, 1993. The Senate version of the bill included a provision to tax Social Security benefits up to 85% but imposed it only after provisional income exceeded new thresholds of $32,000 (for single filers) and $40,000 (for married filers). When the House and Senate versions of the budget package were negotiated in conference, the conference agreement adopted the Senate version of the taxation of Social Security benefits provision and raised the thresholds to $34,000 (for single filers) and $44,000 (for married filers). President Clinton signed the measure into law (as part of P.L. 103-66) on August 10, 1993. Although other changes in tax law have since affected the amount of taxes paid on Social Security benefits, there have been no direct legislative changes regarding taxation of Social Security benefits since 1993. Congressional Research Service 12 Social Security: Calculation and History of Taxing Benefits Appendix. Taxation of Benefits Under Special Situations Lump Sum Distributions A Social Security beneficiary may receive a lump sum distribution of benefits owed for one or more prior years.21 In this situation, a beneficiary may choose between two methods for calculating the taxable portion of the lump-sum distribution: (1) include all of the benefits for prior years in calculating the taxable benefits for the current year or (2) re-calculate the prior year taxable benefits using prior year income and take the difference between the recalculated taxable benefits and the taxable benefits reported in each prior year. In either case, the additional taxable benefits are included in taxable income for the current year. In computing the taxable portion of benefits in prior years, some income sources generally excluded from the provisional income calculation are included.22 Repayments Sometimes a Social Security beneficiary must repay a prior overpayment of benefits. In this case, the calculation of taxable Social Security benefits is based on the net benefits—gross benefits less the repayment—even if the repayment is for a benefit received in a previous year. For married taxpayers filing a joint return, net benefits equal the sum of the couple’s Social Security gross benefits less the repayment. If, however, the repayment results in negative net Social Security benefits, there are two consequences: (1) there are no taxable benefits and (2) the taxpayer may take a miscellaneous deduction as part of itemized deductions or a credit for the negative net Social Security benefits.23 Coordination of Workers’ Compensation For individuals under the full retirement age, Social Security benefits are reduced by a portion of any workers’ compensation payments (or payments from some other public disability program) received by the individual. Workers’ compensation is generally not taxable. Any reduction in Social Security benefits due to the receipt of workers’ compensation is still considered to be a Social Security benefit, however, so income taxes are computed based on the full (unreduced) benefit amount.24 21 An individual originally denied benefits, but approved on appeal, may receive a lump sum amount for the period when benefits were denied (which may be prior years). See Internal Revenue Service, Publication 915, “Lump-Sum Election.” This is not the lump-sum death benefit, which is not subject to federal income tax. 22 See “Lump-Sum Election” in Internal Revenue Service, Publication 915. 23 Miscellaneous itemized deductions are subject to a 2% floor. That is, they are included in itemized deductions to the extent they exceed 2% of adjusted gross income. For details on the repayment computations, see Internal Revenue Service, Publication 915, “Repayments More Than Gross Benefits.” 24 Section 86(d)(3) of the Social Security Act; see also United States Tax Court, T.C. Memo. 2012-249, August 28, 2012, at http://www.ustaxcourt.gov/InOpHistoric/moorermemo.TCM.WPD.pdf. Congressional Research Service 13 Social Security: Calculation and History of Taxing Benefits Treatment of Nonresident Aliens Citizenship is not required for receipt of Social Security benefits. Nonresident aliens may receive benefits provided they have engaged in covered employment and otherwise meet eligibility requirements. In general, 85% of the Social Security benefits for nonresident aliens is taxable (i.e., none of the thresholds apply) at a 30% rate. However, there are a number of exceptions to this general rule on the basis of tax treaties such that nonresident aliens or U.S. citizens living abroad may not have U.S. Social Security benefits subject to U.S. income taxes.25 Withholding In general, withholding for a wage earner is based on the estimated income taxes for a full year of earnings at the periodic (weekly, bi-weekly, monthly, etc.) rate. Taxable Social Security benefits, and the associated taxes, are based on the amount of non-Social Security income earned by a recipient during the tax year. The Social Security Administration, without knowledge about the amount of other income received by a beneficiary, is unable to properly determine the amount of taxes that should be withheld from Social Security benefits. Like other taxpayers, Social Security recipients can make quarterly estimated income tax payments. The Uruguay Round Agreements Act (P.L. 103-465) amended the Internal Revenue Code (IRC) to allow individuals to request that monies be withheld from certain federal payments to satisfy their income tax liability; this is commonly referred to as voluntary tax withholding. An amendment to Section 207 of the Social Security Act allowed this voluntary tax withholding from Social Security benefits.26 Voluntary tax withholding became effective with payments issued in February 1999. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16) permitted voluntary withholding from Social Security benefits at rates of 7%, and equal to the bottom three tax bracket tax rates (currently 10%, 15%, and 25%). The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended the EGTRRA provisions to tax year 2012. The American Taxpayer Relief Act of 2012 (ATRA; P.L. 112-240) made the EGTRRA provisions permanent. Aliens residing outside the United States are subject to different tax withholding rules. Section 871 of the Internal Revenue Code imposes a 30% tax withholding rate on almost all of the U.S. income of nonresident aliens, unless a lower rate is fixed by treaty. Thus, 30% of 85% (or 25.5%) of a nonresident alien’s Social Security benefits may be withheld for federal income taxes. 25 Internal Revenue Service, Publication 915, “Nonresident aliens,” provides a list of the countries whose citizens (as nonresident aliens) are exempt from U.S. income taxes on Social Security benefits, and countries where residing U.S. citizens are exempt. 26 Because they are not subject to the federal income tax, Supplemental Security Income payments, Black Lung payments, Medicare premium refunds, Lump Sum Death Payments, returned check re-issuances, and benefits due before January 1984 are not subject to voluntary tax withholding. Congressional Research Service 14 Social Security: Calculation and History of Taxing Benefits Author Contact Information Noah P. Meyerson Analyst in Income Security nmeyerson@crs.loc.gov, 7-4681 Congressional Research Service 15