Tax Social Security and Railroad Retirement Benefits in the Same Way That Distributions From Defined Benefit Pensions Are Taxed

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 17.9 36.7 38.5 40.5 42.6 44.7 46.9 49.3 51.7 54.2 176.2 423.1

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

Under current law, less than 30 percent of the benefits paid by the Social Security and Railroad Retirement programs are subject to the federal income tax. Recipients with income below a specified threshold pay no taxes on those benefits. Most recipients fall into that category, which constitutes the first tier of a three-tiered tax structure. If the sum of their adjusted gross income, their nontaxable interest income, and one-half of their Social Security and Tier I Railroad Retirement benefits exceeds $25,000 (for single taxpayers) or $32,000 (for couples who file jointly), up to 50 percent of the benefits are taxed. Above a higher threshold—$34,000 for single filers and $44,000 for joint filers—as much as 85 percent of the benefits are taxed.

By contrast, distributions from defined benefit plans are taxable except for the portion that represents the recovery of an employee's "basis"—that is, his or her after-tax contributions to the plan. In the year that distributions begin, the recipient determines the percentage of each year's payment that is considered to be the nontaxable recovery of previous after-tax contributions, based on the cumulative amount of those contributions and projections of his or her life expectancy. Once the recipient has recovered his or her entire basis tax-free, all subsequent pension distributions are fully taxed. (Distributions from traditional defined contribution plans and from individual retirement accounts, to the extent that they are funded by after-tax contributions, are also taxed on amounts exceeding the basis.)

This option would treat the Social Security and Railroad Retirement programs in the same way that defined benefit pensions are treated—by defining a basis and taxing only those benefits that exceed that amount. For employed individuals, the basis would be the payroll taxes they paid out of after-tax income to support those programs (but not the equal amount that employers paid on their workers' behalf). For self-employed people, the basis would be the portion (50 percent) of their self-employment taxes that is not deductible from their taxable income. Under this option, revenues would increase by $423 billion from 2017 through 2026, the staff of the Joint Committee on Taxation estimates.

An argument in favor of this option concerns equity. Taxing benefits from the Social Security and Railroad Retirement programs in the same way as those from defined benefit pensions would make the tax system more equitable in at least two ways. First, it would eliminate the preferential treatment given to Social Security benefits but not to pension benefits. For low- and middle-income taxpayers especially, that preference can cause elderly people with similar income to face very different tax liabilities depending on the mixture of retirement benefits they receive. Second, it would treat elderly and nonelderly taxpayers with comparable income the same way. For people who pay taxes on Social Security benefits under current law, the option could also simplify the preparation of tax returns. Instead of taxpayers' calculating the taxable portion themselves, the Social Security Administration—which would have information on their lifetime contributions and life expectancy—could compute the taxable amount of benefits and provide that information to beneficiaries each year.

This option also has drawbacks. It would have the greatest impact on people with the lowest income: People with income below $44,000, including some who depend solely on Social Security or Railroad Retirement for their support, would see their taxes increase by the greatest percentage. In addition, raising taxes on Social Security and Railroad Retirement benefits would be equivalent to reducing those benefits and could be construed as violating the implicit promises of those programs, especially because the option would provide little or no opportunity for current retirees and people nearing retirement to adjust their saving or retirement strategies to mitigate the impact. Finally, more elderly people would have to file tax returns than do so now, and calculating the percentage of each recipient's benefits that would be excluded from taxation would impose an additional burden on the Social Security Administration.