As with many areas of financial planning, there is not a blanket statement I can…
The Most Evil of All Income Taxations – It’s Time for Change
The estate tax, alternative minimum tax, inheritance tax, and Federal Insurance Contributions Act (FICA) are just a few of the ways governmental taxation takes on an evil form at various income levels in the United States. Evil, here, referring to the pretenses upon which these forms of taxation were brought forth and their history of being manipulated for political power.
In opposition to these forms of taxation are Adam Smith’s four canons of a just governmental taxation system – the hallmarks of legitimacy in taxation. Smith’s four canons are:
- All must pay some portion of taxes respective to their ability to do so
- Tax must be certain and not arbitrary
- Tax must be consistent and convenient to pay when due
- The tax system should try to take as little from the taxpayers for the needs of the government
The most evil form of taxation is the way in which social security is taxed as income. In the beginning, social security was intended to be 100% tax-free income to all beneficiaries, no matter their income. In 1983, the United States Congress passed a law to include one’s social security income in their taxable income if their social security income (and other forms of income) exceeded $25,000 for single filers or $32,000 for married filers. In 1993, congress amended the law to tax 85% of every dollar over $34,000 for single filers and $44,000 for married filers. Congress’s rationale behind the taxation of social security was that it should be taxed like a pension system, but how much logic is truly behind this reasoning?
Before this question can be answered, let’s look at the social security system. Every year, 6.2% of one’s income is payed into the Social Security Insurance system: Old Age, Survivors and Disability Insurance. Note that the word “insurance” is used, as social security is not a pension. In this system, the government takes enough money from filers who work so that it can be shared with filers who are retired and help ensure retirees do not fall into poverty during that stage of their life. In the interest of fairness, the government promised all those who contributed to social security during their working years that they would receive some benefit in their retired years, regardless of assets and income. The lowest-earning taxpayers receive the highest payout of benefits in retirement compared to taxes paid during working years and vice versa for the highest-earning taxpayers. Social security is a social insurance program designed to either keep retirees out of poverty or provide one-third of their retirement income needs.
Social security taxes amount to 6.2% of an employee’s wages, with the employer matching an additional 6.2% of wages. The 6.2% paid by the employee comes from income after taxes. That means if you make $50,000, you pay $3,100 in social security tax, but still must pay income taxes on the full $50,000. Social security taxes are paid at a 6.2% rate up to $142,800 limit in 2021. That is $8,853 of social security paid with an employee’s after-tax dollars with one’s employer paying an additional $8,853.
Social security is not optional – all United States citizens, as well as the vast majority of noncitizens living in the United States, must pay the social security tax. The system cannot work as intended if not forced on all taxpayers. In contrast, an individual does have a choice when it comes to a pension plan: it is their choice to work with the employer offering the pension or to look for work elsewhere.
If social security is an insurance and not a pension, what reason would Congress have for taxing it as such? The underlying reason was not palatable for voters at the time but may bring clarity to us today. The truth is that social security had been grossly overestimated when it was established and then expanded upon without actuarial logic to the point where it resembled a Ponzi scheme. There were about 15 workers for every retiree in the 1930s and that number began to drop in the 1960s to 5 to 1; today that ratio is 3 to 1, due to changes over time in life span. As in a Ponzi scheme, if the base shrinks, the pyramid can no longer stand. Additionally, many retirees in the mid to late 1900s exponentially grew their wealth and it was clear they did not require the full extent of the benefits they were receiving, in contrast to the retirees of the 1930s.
Means testing was conducted to determine who had a greater need for the social security benefits, but was grossly unpopular. In 1981, the Social Security Commission, headed by Alan Greenspan, ruminated over the question of how to save the long-term viability of social security given new actuarial information. The commission’s response was to raise taxes and the wage base on social security, increase retirement age, and tax social security benefits.
Why decide to tax social security benefits instead of finding an alternative solution? The government benefitted from means testing social security benefits and could provide an explanation for doing so that could be explained to voters in a way that did not cause a rebellion. Telling political half-truths about social security in the interest of securing votes may have seemed like a decent idea at the time, but those decisions made 40 years ago are now causing many low-income retirees to suffer the heavy hand of governmental taxation.
Let us return to Adam Smith’s canons of taxation and assess how the federal government’s taxing of social security applies to each for low-income retirees (defined as receiving less than $75,000 per year):
- Pay according to ability: low-income seniors already pay an amount of tax equal to their ability
- Non-arbitrary taxation: tax is uncertain and dependent on realization of other incomes like capital gains and IRA withdraws
- Consistent and convenient to pay: tax is anything but consistent and it normally hits low-income seniors by surprise when a tax year of extra income makes more social security taxable unexpectedly
- Taxed as little as possible: low-income seniors paid far more of their overall income to taxes due to the regressive nature of FICA taxes
On all four counts, the taxation of social security on low-income retirees fails miserably, but there are still more condemning facts that attest to the nefarious nature of how social security is taxed. In 1983, the taxation of social security (in essence, means testing as discussed above) was set at 50% of social security for every dollar exceeding $25,000 single and $32,000 married. The cumulative inflation rate since 1983 is 167% (according to inflationtool.com). The equivalent single taxpayer after inflation who should begin paying taxes on social security in 2021 is $66,750; for married, it is $85,440. In 1993, the taxation (means testing) of social security went from 50 cents per dollar to 85 cents per dollar for single incomes over $34,000 and married incomes over $44,000. The inflation rate since 1993 was 84% (according to inflationtool.com). The equivalent single taxpayer reporting the 85% of social security as income would be $62,560; married would be $80,960. Does the low-income senior of 2021 really deserve to be paying taxes on their social security income when their equivalents in 1983 or 1993 were not?
Why is there no outrage over the injustice of the taxation of social security? In 1983, most seniors had a pension as well as social security to live on. Today, many seniors live on the withdraws from an IRA or 401K, which therefore creates more taxable income. Many low-income seniors may now have capital gains every so often, creating a substantial increase in taxable social security. Doing over 400 tax returns per year, I see the harm of social security taxation on those making under $75,000 and for most, that harm is unexpected.
A true story is the best way to make this point. One year I completed a tax return for a 75-year-old single woman who worked part time as an office manager making about $18,000 salary with $0 of taxable social security income and no other sources of income. She had a federal income tax of $1,000 and paid an additional $1,377 in FICA tax on her salary, which was of trivial benefit, if any, since she was already qualified for Medicare and receiving social security benefits. The next year, out of the kindness of her heart, she withdrew $10,000 from an IRA to give $5,000 to each of her two grandsons. That $10,000 withdraw brought in $3,000 of taxable social security income and increased her normal federal income tax from $1,000 to $3,300 (a 23% marginal tax rate on her $10,000 IRA withdraw). Her total income for the year was $34,000, and not including state income tax, her federal tax bill was $3,300 income tax plus $1,377 FICA tax for a total of $4,677 (an effective federal tax rate of 14%). The state of Maryland took an additional $1,900 in taxes for a total tax rate of 19.3%.
You be the judge if the way low-income retirees’ social security is taxed aligns with Smith’s four canons of taxation or whether our tax system would benefit from a reform that is created with these canons in greater focus.