Why are Social Security benefits taxed?

Hey, I paid in all of this money over my career. Now that I’m taking money back out of it, they’re taxing me again. Seems like I’m paying taxes on tax money I paid in. Why are Social Security benefits taxed?

This question comes up pretty regularly – and recently it came up again via Twitter from a reader. I’ll give this my best explanation – but you have to grant me a favor: Please understand that in my explanation I am not defending the practice, I am simply explaining why Social Security benefits are included as taxable income.

Let’s start with a history lesson. Originally, Social Security benefits were not taxed at all. This is because of the nature of the benefits – your benefits are NOT a return of the taxes you have paid into the system. Congress originally looked at this as a gratuity, rather than income, to the beneficiary. This is because the benefit is completely unrelated to the amount of taxes you have paid in.

In fact, several classes of beneficiaries receive a significant amount more in benefits than they ever paid in Social Security taxes, if any taxes were paid at all. Spousal and dependents’ benefits, disability benefits, and survivor benefits are the main ones that come to mind. For example, a minor child’s benefit being received as a result of a parent’s receiving Social Security benefits does not result from the amount of taxes that the child or the parent paid into the system. Otherwise, a childless Social Security beneficiary would be eligible for a larger benefit payment when compared to a beneficiary with a child under age 16.

Benefits are instead related to the amount of income that you have received on your record, not the amount of taxes you paid in. This has been the case since the beginning of the Social Security system. In fact, the revenue-generating portion of the Social Security Act is a completely separate Title in the law from the benefit payment Title.

1983 – up to 50% of Social Security benefits taxed

The non-taxable nature of Social Security benefits continued until the amendments to the Social Security Act of 1983. Among many sweeping changes to the Social Security system, this enacted law included a provision to tax Social Security benefits, returning the corresponding tax revenues to the Social Security trust fund.

The reasoning behind this is that Social Security benefits are not a gratuity as originally proposed, but rather a retirement income, much like a pension. Taxation of pension as income is broken up in to two pieces: the part that the employee contributes, if it was subject to income tax, is not included as taxable income; while the employer’s portion and any portion that was contributed pre-tax to the pension is subject to income taxation.

Since Social Security benefits are not exactly the same as a pension, the calculation of the tax on benefits is only a rough estimate of the portion that might be considered as the “after tax” contribution of the employee, and then only at the time of the legislation. This calculation has only slightly changed over the years and as a result has no relation to any consideration of comparing Social Security benefits to pensions at this day and age.

From the beginning, Social Security benefits have been paid for by three sources: your own Social Security tax paid into the system, your employer’s Social Security tax paid into the system, and interest on the balance in the Social Security trust fund, invested in Treasury securities. As of 1983, these three sources weren’t enough to keep the trust fund liquid and regularly paying benefits as promised. In addition to increasing the payroll tax rate, increasing future benefit eligibility ages and other changes, the Social Security amendments of 1983 included the provision to tax Social Security benefits.

The nature of the original taxation was that a threshold was first allowed ($25,000 for singles and $32,000 for married couples), and above these amounts of provisional income* up to 50% of Social Security benefits would be included in taxable income. The revenue from this taxation is added to the appropriate Social Security trust fund as an additional revenue source.

*Provisional income is all other sources of taxable income, plus tax-free interest, plus 50% of the amount of Social Security benefits. Any amount of provisional income above the threshold, up to 50% of the total Social Security benefit, was included in taxable income.

The thresholds mentioned above were put into place to provide relief for low income individuals. These amounts are not in any way related to Social Security benefits, they are a pure function of tax law. The thresholds were intentionally not subject to future cost-of-living indexing, such that as time passes and inflation of incomes occurs, fewer and fewer beneficiaries will benefit from this relief. It was a hidden future benefit reducer mixed in with the legislation at the time. This has often come up as a question as well – “How come those thresholds are never increased? They’re woefully out of date!” It was intentional that they would eventually become less and less beneficial over time.

This arrangement continued for 10 years, when another adjustment was made.

1993 – up to 85% of Social Security benefits taxed

In 1993, as a part of the Omnibus Budget Reconciliation Act, a provision was added to bump up the included level of Social Security benefits taxed. Under this provision, a second threshold level was added: $34,000 for singles and $44,000 for married couples. When provisional income (see above) is greater than this second threshold level, up to 85% of Social Security benefits are included as taxable income. This 85% level is the maximum amount (under present law) that Social Security benefits are included as taxable income.

The reasoning behind this update was to bring the taxation of Social Security benefits into closer alignment with the way other retirement income is included as taxable income.

Once again, the thresholds are not indexed to inflation, so in the future these “relief” thresholds will become less and less beneficial to recipients and more Social Security benefits are included as taxable income, bolstering the trust fund further.

Let’s get back to the original question now. For further details see this article on how Social Security taxation works.

Why are Social Security benefits taxed?

Now that the history lesson is complete, let’s answer the question.

Social Security benefits are not like a savings account, they’re more like an insurance product. The Social Security benefits that you receive are not based on the amount of tax that you paid into the system. Much the same as with your auto insurance, you shouldn’t think of it as putting X dollars in, so you should get X dollars back out. With auto insurance you’re paying money in so that if the adverse event occurs (you wreck your car), the insurance company will give you money to repair or replace the car. Social Security benefits insure against the adverse event of living too long. Regardless of how much you paid in taxes into the system, your Social Security retirement benefit will continue to be paid out to you no matter how long you live. And after you die, if you have a surviving spouse and/or qualified surviving dependents, they will continue to be paid as well.

Since these benefits are not directly tied to the amount you paid into the system, the amount you receive in benefits is effectively a retirement income. With the thresholds on provisional income and the levels of inclusion (0%, 50% and 85%) you are getting relief for a portion of the money that you did pay in as Social Security tax. Depending on your income level, it’s quite likely that the “relief” is a paltry amount and nowhere near what you paid in for taxes over the years – but that’s the nature of an insurance plan. Some folks come out way ahead with a very long life of benefits, possibly based on very little income by comparison. Others pay into the system for their entire careers and never receive a penny in Social Security benefits because they died before starting to receive the benefit.

Otherwise, if Social Security worked like a savings account, we’d see headlines all the time about folks in their 80’s and 90’s, dependent on Social Security benefits for a significant portion of their livelihood, discovering that they’ve “used up” the money they contributed over the years. And we don’t want that, right?