Retirement Assets Among Many Potential Targets for Tax Reform

One proposed avenue of tax reform would treat the Social Security and Railroad Retirement programs in the same way that defined benefit pensions are treated.

The large annual budget deficits projected under current law have many tax experts contemplating ways the federal government could bring in additional revenue; the Congressional Budget Office (CBO) has published a paper exploring more than 100 potential avenues for reform.

The extensive research paper estimates the budgetary effects of each approach and highlights some of the advantages and disadvantages of each, including options that would impact the tax treatment of assets allocated pre-tax for retirement.

One such option suggested is to “tax Social Security and Railroad Retirement benefits in the same way that distributions from defined benefit pensions are taxed.” According to CBO researchers, “under current law, less than 30% 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.”

The researchers further note that if the sum of this group’s 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% 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.

The paper continues: “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.”

CBO suggests this tax reform approach 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).

“Under this option, revenues would increase by $423 billion from 2017 through 2026,” the paper suggests. “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.”

NEXT: Various other tax reforms suggested 

Other approaches explored by CBO include eliminating the concurrent receipt of retirement pay and disability compensation for disabled veterans, and reducing pensions in the federal employees’ retirement system. Also floated is raising the full retirement age for Social Security.

Dissecting the latter approach, CBO researchers observe the age at which workers become eligible for full retirement benefits from Social Security—the full retirement age (FRA)—already depends on their year of birth. For workers born in 1937 or earlier, the FRA was 65. It increased in two-month increments for each successive birth year until it reached 66 for workers born in 1943.

“For workers born between 1944 and 1954, the FRA holds at 66, but it then increases again in two-month increments until it reaches age 67 for workers born in 1960 or later,” the paper explains. “As a result, workers who turn 62 in 2022 or later will be subject to an FRA of 67. The earliest age at which workers may start to receive reduced retirement benefits will remain 62; however, benefit reductions at that age will be larger for workers whose FRA is higher. For example, workers born in 1954 (whose FRA is 66) will receive a permanent 25% reduction in their monthly benefit amount if they claim benefits at age 62 rather than at the FRA, whereas workers born in 1960 (whose FRA is 67) will receive a 30% benefit reduction if they claim benefits at 62.”

Under this reform option, the FRA would continue to increase from age 67 by two months per birth year, beginning with workers turning 62 in 2023, until it reaches age 70 for workers born in 1978 or later (who turn 62 beginning in 2040). As under current law, workers could still choose to begin receiving reduced benefits at age 62, but the reductions in their initial monthly benefit from the amounts received at the FRA would be larger, reaching 45% when the FRA is 70.

CBO researchers speculate that any increase in the FRA “would reduce lifetime benefits for every affected Social Security recipient, regardless of the age at which a person claims benefits. A one-year increase in the FRA is equivalent to a reduction of about 6% to 8% in the monthly benefit, depending on the age at which a recipient chooses to claim benefits. Workers could maintain the same monthly benefit by claiming benefits at a later age, but then they would receive benefits for fewer years.”

This option would shrink federal outlays by $8 billion through 2026, the Congressional Budget Office estimates.

“By 2046, the option would reduce Social Security outlays from what would occur under current law by 7%; when measured as a percentage of total economic output, the reduction would be 0.5 percentage points, because outlays would fall from 6.3% to 5.8% of gross domestic product,” the report concludes. “Because many workers retire at the FRA, increasing that age is likely to result in beneficiaries’ working longer and claiming Social Security benefits later than they would if a policy with identical benefit cuts at each age was implemented by adjusting the benefit formula.”

The full report is available for download here