Tax-Free Social Security Would Help Middle-Class Clients

The pending legislation is the second effort in less than a year to remove Social Security income from federal taxation.

John Gehri
John Gehri

One of the longest running government programs may be getting a tweak.

U.S. Rep. Angie Craig (D – Minn.) in August introduced the You Earned It, You Keep It Act, which calls for repealing taxes on Social Security Benefits.

The bill, H.R. 8717, has been referred to the House Committee on Ways and Means, as well as the Committee on Energy and Commerce.

“Social Security is a promise we have made to the American people – if you work hard and play by the rules, the dignity of a secure retirement will be within your reach. But taxing the very benefits American workers have earned after decades on the job diminishes our promise and threatens to undermine the financial security of retirees already struggling with rising prices,” said Rep. Craig in a statement.Eliminating this tax will help Social Security benefits go further and ensure that American retirees have all the resources they need after a lifetime of hard work.”

Current tax policy

Eliminating taxes on Social Security benefits is likely to positively impact your retired clients. The federal government currently taxes up to 85% of Social Security benefits after annual “combined income” exceeds $34,000 for taxpayers filing individually and $44,000 for spouses filing a joint return. Combined income (previously referred to as provisional income) is the sum of a taxpayer’s adjusted gross income, nontaxable interest and half of their Social Security benefits.

If the bill becomes law, it could help even lower-income retirees. Up to 50% of Social Security benefits are taxed for individual filers with combined income of $25,000 to $34,000 per year and joint filers with $32,000 to $44,000

This uniformity for taxation on benefits ends at the federal level.  As of 2022, 12 states tax Social Security. It’s hard to say whether states that currently tax Social Security will change their state taxes on the benefits if this bill passes in Congress. Regardless, many beneficiaries would still save on federal taxes.

The average Social Security benefit was $1,544.70 in July 2022. This represents $18,536.40 per year for a single person and $37,072.80 for a couple.

Proposal

To fund the repeal of taxation on Social Security benefits, the You Earned It, You Keep It Act proposes extending the Social Security payroll taxes. Beginning in 2023, workers would be assessed a Social Security tax on wages up to $250,000. Wages topping $147,000 are currently exempt from the Social Security payroll tax.

Interestingly Sec. 3(b) of the bill would make this tax change retroactive back to January 1, 2022 for self-employed persons. But in a nod to fairness, Sec. 4 would base future Social Security retirement benefits for the self-employed on the increased taxable income from self-employment up to the $250,000 amount.

What Does This Mean?

The proposed bill will not reduce taxes for many Social Security recipients because their total income is below the taxable thresholds.

However, for financial planning clients, this legislation could present opportunities. For example, they could recognize additional capital gains or make Roth conversions while maintaining the same level of federal taxation. If Social Security is not taxed, then for tax purposes people can “replace” the Social Security income with income from other sources, such as capital or a Roth conversion, and their tax bill would be the same. Of course, maybe if the government removes Social Security from taxation they’ll raise the capital gains rate, but we don’t know that!

Consider this example: A couple in the 24% tax bracket with $60,000 of Social Security income currently owes $12,240 in taxes ($60,000 x 85% x 24%) on their Social Security income.  Under the proposed bill, the couple could recognize an additional $81,600 in long-term capital gains in the 15% capital gains bracket ($81,600 x 15% = $12, 240) or $51,000 of conversion income at the same 24% and keep their federal tax bill the same. These alternate ways to recognize income could have long-term benefits for them or their beneficiaries.  Over a ten-year period, this would provide a significant opportunity to lower the total taxes due for this couple.

As an alternative, your clients could use this $12,240 reduction of tax expense to cover the cost of a car payment or to increase charitable giving.

It’s a start …

Why hasn’t H.R. 8717 gained traction since being introduced? The bill, which has no cosponsors, was unfortunately submitted to committee only eight days before the White House announced a decision on student loans, so Congress was preoccupied.

A similar bill went nowhere. Rep. John B. Larson (D-CT) and Sen. Richard Blumenthal (D-CT)  introduced it on October 26, 2021. Since then, it hasn’t moved out of committee due to the partisan divisions that are currently present in Congress.

In typical Washington fashion, I expect the usual suspects to delay this bill because the beneficiaries will primarily be higher-income seniors and not the larger number of lower-income recipients. Here’s hoping that I’m wrong about that.

John M. Gehri, CFP, ChFC is a licensed investment advisor representative with Harvest Financial Advisors in the Cincinnati/West Chester, Ohio area. He may be reached at john@harvestadvisors.com. This article is for informational purposes only. Any commentary and third-party sources are believed to be reliable but Harvest Financial Advisors cannot guarantee their accuracy.

 

 

 

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