Ending the tax on Social Security income should be part of a broader reform

It’s one of those unwelcome surprises that really angers people when they retire: income from Social Security benefits are subject to taxes. So it comes as no surprise to see Donald Trump dangling elimination of the tax as one of the novel tax cut ideas he’s been tossing at voters this summer. No doubt about it, this will appeal to some older voters.

Reducing or eliminating the tax on benefits enjoys bipartisan support in Congress, and Democrats also have proposed variations on the idea. But unlike Trump, they have proposed ways to pay for the tax cuts, which would cost Social Security and Medicare $1.5 trillion in revenue over the coming decade.

Social Security already faces a solvency problem. The latest estimate from the trustees who oversee Social Security shows that the combined retirement and disability trust fund reserves will be depleted in 2035. At that point, the program would be bringing in enough cash to pay only 83% of the benefits promised to current and future beneficiaries. Absent any other changes, that would mean a 17% across-the-board cut in benefits.

Revenue from the tax on benefits helps fund Social Security retirement and disability benefits and Medicare Part A (hospitalization); eliminating the tax without paying for it would hasten Social Security’s insolvency by as much as two years (to 2033), and as much as six years for the Medicare Part A trust fund (to 2030 instead of 2037), according to the Tax Foundation.

Averting trust fund exhaustion is job one when it comes to Social Security reform. A report by the Urban Institute found that allowing the trust fund to run dry would increase the number of beneficiaries living in poverty by more than 50%, with a disproportionate impact on people of color. Meanwhile, eliminating the benefits tax would help only middle- and higher-income seniors, due to the way the tax is structured.

Taxing Social Security income may be unpopular, but from a policy standpoint it’s worth pointing out that it’s consistent with the way we tax other types of retirement income, including pensions and 401(k) accounts. As a general matter, sensible tax policy should treat all income equally. But that argument isn’t likely to sway many retirees - or voters - who understandably are surprised to learn that a federal benefit is to be taxed.

In my Reuters column this week, I examine the history of the tax on Social Security benefits and the formula that determines how much income is taxed - and the implications of reforming or eliminating the tax.

While we’re on the topic of Trump’s tax cut pitches . . .

Economist Dean Baker notes that eliminating the tax on tips doesn’t really make sense - as noted above, income is income from a tax policy standpoint.

But Baker adds that eliminating the tax on tips will hurt workers when it comes time to retire - because it will translate to substantially lower Social Security benefits.

Benefits are calculated on lifetime average earnings. If tips are excluded from that wage formula, Baker calculates that a reduction in average lifetime earnings of $3,000 per month would translate to a drop of about $225 monthly for the typical worker earning income from tips.

ICYMI: ERISA turned 50 this week

The federal law that shaped much of the current retirement benefit landscape was signed into law 50 years ago this week - the Employee Retirement Income Security Act, or ERISA.

The law protected private sector pensions by imposing funding requirements, rules for employee eligibility and fiduciary standards requiring plan sponsors to act solely in the interest of its participants. It also created the Pension Benefit Guaranty Corporation, a federally sponsored insurance fund that backstops failing pension plans. But those tighter requirements and costs led many employers to stop offering traditional pensions and to the rise of 401(k) plans and Individual Retirement Accounts and their dominance in the private sector today.

Earlier this summer, I assessed the impact of ERISA for The New York Times. If you missed that story, here’s a link.

And last week, I joined Ivanna Hampton of Morningstar to talk about ERISA’s impact on the retirement landscape. Here’s the video:

Finally, Democrats campaign on their huge pension rescue

I’ve been waiting to hear Democrats start campaigning on the Butch Lewis Act - the milestone law passed by the Biden administration that has saved one million pensions. I wrote about this extraordinary law back in March as it turned three years old. As part of a $1.9 trillion Covid stimulus bill, Congress approved an $86 billion Democrat-sponsored package for multiemployer plans facing insolvency to apply for one-time federal grants that would keep them viable until at least 2051. The law solved a very tough, complex problem.

Butch Lewis should translate into strong support from organized labor for Vice President Kamala Harris in November, and it was on the list of achievements she touted at a Labor Day rally in Pittsburgh earlier this week. The White House estimates that the aid will ultimately protect the benefits of two to three million workers.

What I’m reading

Changes in retirement savings rules to know before year’s end . . . Key factors to consider on 401(k) rollovers when you retire . . . How hearing and vision loss increase risk for dementia . . . Medicare’s opioid limits didn’t protect these seniors . . . Why fewer people get to be grandparents . . . Fee-cutting is changing the way we buy and sell homes . . . Boomer are selling small businesses to millenial buyers at a record pace . . How to plan for retirement if you’re behind on saving at midlife . . . Looking for twilight love in Shanghai . . . Young Americans can’t keep funding boomers and beyond . . . Scientists see aging waves at 40 and 60.