In most years since 1975, Social Security beneficiaries receive a cost-of-living adjustment (COLA) to their payments. The COLA is based on the percentage increase in the Consumer Price Index for urban wage earners and clerical workers, according to Social Security.
Earlier this month, the U.S. Social Security Administration said that it will boost the COLA in 2022 by 5.9% — the most in nearly four decades, as rising inflation puts a big dent in the purchasing power of those on fixed incomes.
The reason for the relatively big increase? Soaring inflation this year — the CPI rose 5.3% over the year ending August 2021 — has deeply eroded the buying power of Social Security benefits, according to a study by the Senior Citizens League.
The purpose of the COLA is to ensure that the purchasing power of Social Security and Supplemental Security Income benefits is not eroded by inflation. And the recent spurt in inflation is an important reminder that keeping pace with the cost of living is one very valuable feature of Social Security, according to a recent report from the Center for Retirement Research at Boston College.
However, some of the inflation protection offered by Social Security’s COLA could be undermined by two factors, according to the Center for Retirement Research report:
- Medicare Part B premiums – deducted from Social Security benefits up front – tend to grow faster than the COLA; and
- a growing portion of benefits is subject to income tax.
These factors, according to the Center for Retirement Research, reduce the net benefit that retirees get to cover shelter, food, and clothing.
What to make of this?
First, the problem is likely to get worse before it gets better. But there are solutions.
The dual effect of rising healthcare costs in the form of Medicare Part B premiums and Social Security income taxation thresholds that are not indexed will continue this net decrease if changes are not implemented, said Martha Shedden, co-founder of the National Association of Registered Social Security Analysts.
According to Shedden, the two are different problems with possible varied solutions.
First, Medicare Part B premiums will always be a retirement cost, whether the payments are deducted from Social Security benefits or paid out of pocket. “The reason this expense has such an impact on retirees’ income is due to the rise of healthcare costs for seniors that are not appropriately accounted for when calculating COLAs for retirees,” she said.
Indeed, healthcare inflation historically outpaces the rate of general inflation.
A solution, she said, would be to have retiree-specific healthcare (Medicare) costs indexed to the Social Security COLAs. At present Part B premiums are indexed to inflation but not to wages.
And second, the taxation of Social Security benefits has slowly been affecting more and more retirees over the years since the combined income threshold amounts have never been indexed to inflation since they were implemented in 1983 and 1994, said Shedden.
“I don’t know if this was the plan from the beginning, to slowly collect income taxes from a greater number of retirees over the years, but it’s certainly been the result of no indexing,” she said. “And without a major change in the law to index the Social Security taxation thresholds, the number of people who have up to 50% or 85% of their Social Security income taxed will continue to increase,” said Shedden.
This is how those Social Security taxes work:
If you file a federal tax return as an "individual" and your combined income (adjusted gross income plus nontaxable interest plus one-half of your Social Security benefits)
- is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits.
- If it's more than $34,000, up to 85% of your benefits may be taxable.
If you file a joint return, and you and your spouse have a combined income that
- is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits.
- If it is more than $44,000, up to 85% of your benefits may be taxable.
There are, however, certain financial planning strategies that retirees can use to help manage, and perhaps reduce, the amount of their Social Security that is taxed, said Shedden.
This involves a detailed analysis of the retirees’ other finances, such as which are held in retirement funds subject to required minimum distributions (RMDs) and which are not. RMDs, said Shedden, “are 100% taxable, but Social Security income is given a tax preference in the way that it is calculated.”
It also involves examining what funds are available to use to cover any income gap if they decide to delay claiming Social Security, said Shedden.
“Those in the ‘mass affluent’ demographic — neither very low or high income in retirement — may be able to reduce the taxation of their Social Security and general income by withdrawing from funds in a tax-efficient sequence,” said Shedden.
More from Retirement Daily: