Biggest increase in Social Security since 1982 brings bad news for retirees

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Inflation has soared to a four-decade high this year, so Social Security benefits will receive an exceptionally high COLA (Cost of Living Adjustment) of 8.7% in 2023. That’s the biggest increase for retired workers since 1982 and the fourth largest lift in history. While this certainly qualifies as good news, the historic COLA could come with two nasty surprises.

Here are the details retired workers need to know.

A retired couple sat at the kitchen table discussing finances.

Image source: Getty Images.

More retirees must pay federal income tax on Social Security benefits

Initially, Social Security benefits were exempt from federal income tax. But Congress changed the law in 1983, authorizing the taxation of benefits for individuals whose income exceeded certain thresholds. A second (higher) limit was added in 1993.

Strangely, these limits have never been adjusted for inflation. This is problematic because the benefits I have was corrected for inflation. In other words, every COLA applied to benefits since 1983 has pushed more beneficiaries over the income threshold. In fact, less than 10% of recipients owed Social Security income taxes when the law took effect, but that number is around 50% today, and a large COLA in 2023 will add momentum to the problem.

In most cases, beneficiaries who derive all of their Social Security income pay no tax on benefits. But those with additional sources of income — like a job, 401k distributions, or traditional IRA distributions — could find themselves on the wrong side of the income thresholds next year.

Tax liability depends on (1) reporting status and (2) blended income, which is defined as the sum of modified adjusted gross income plus one-half of Social Security benefits. Here are the details:

  • Individual contributors: If the combined income falls between $25,000 and $34,000, up to 50% of Social Security benefits are taxable; if the combined income exceeds $34,000, up to 85% of Social Security benefits are taxable.
  • Married taxpayers (joint declaration): If the combined income falls between $32,000 and $44,000, up to 50% of Social Security benefits are taxable; if the combined income exceeds $44,000, up to 85% of Social Security benefits are taxable.

Beneficiaries who owe taxes on Social Security benefits have two options. They can make estimated quarterly payments to the Internal Revenue Service, or they can request that federal taxes be withheld from benefits by filing a Form W-4V.

Also of note, retired workers should keep in mind that 12 states also tax Social Security benefits.

Social Security trust fund may be depleted sooner than expected

The aging Baby Boomer population has created a financial problem for the Social Security program: costs are rising faster than revenue. In fact, the Social Security program ran a deficit of $56 billion in 2021, and this trend is expected to continue indefinitely.

And? Social Security’s trust fund is set to run out by 2035, and the program faces a $20 trillion shortfall through 2096, according to the Board of Trustees. That doesn’t mean retired workers will lose benefits altogether, but it could lead to a pay cut if Congress doesn’t address the issue. Specifically, if the trust fund is depleted by 2035, income taxes would only cover 80% of scheduled benefits.

Unfortunately, the Board of Trustees did not anticipate a COLA of 8.7% in 2023. The projections discussed in the previous paragraph are based on the assumption that benefits would increase by no more than 5.14% in the next year. In other words, Social Security’s unusually large COLA could accelerate the depletion of the Social Security trust fund.

On the bright side, politicians in Washington are well aware of the problem, and many administration officials have proposed possible solutions.