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The Tax Consequences of Social Security and Privatization

It is certainly not clear whether privatization of Social Security will become a reality. It is also not clear how this privatization will affect your overall tax bill.

However, from the proposals currently being considered, it appears that changes to our Social Security system will likely increase payroll taxes for workers and have mixed affects on the taxation of retirement benefits. Under current law, there are two ways in which your tax bill is affected by Social Security:
1) Social Security payroll taxes and
2) federal income taxes on the Social Security benefits you receive in retirement or on disability. Let’s begin with the payroll taxes.

Payroll Tax System
Your compensation, whether in the form of wages, salaries or self-employment income, is subject to Social Security payroll taxes. As an employee, you pay 6.2% of your compensation. In addition, your employer matches these taxes. If you’re self-employed you pay the entire Social Security tax, amounting to 12.4%.

The Social Security tax is applied to compensation up to a yearly maximum of $90,000. (This income ceiling is increased annually.) That means that, once your compensation reaches $90,000, you are finished paying Social Security taxes for the year.

Looking at current proposals to shore up Social Security, it seems likely there will be an increase in payroll taxes. Some proposals advocate raising payroll taxes by 2%. Other proposals suggest removing the cap on compensation subject to Social Security taxes or applying a reduced tax rate above a certain income level. Either way, this amounts to a tax increase on working people. If the cap is eliminated, for every $10,000 of salary above $90,000, you would pay at least $620 more in Social Security taxes each year. Self-employed people would pay $1,240 more per year. Since payroll taxes apply to gross wages, not taxable income, there are very few planning opportunities to reduce these taxes.

Retirement and Disability Benefits
Social Security retirement and disability benefits have been taxable to higher-income taxpayers for some time now. Single persons with taxable income over $34,000 and married filers with income over $44,000 pay tax on 85% of the benefits. The proposal to privatize a portion of Social Security will not solve the system’s financing problems. Therefore, it will likely be combined with a reduction of Social Security retirement benefits.

This would have the effect of lowering your income in retirement, and consequently your income taxes. The net effect of privatization on your income tax bill will depend on the amount of time you participate in private retirement accounts. If you are closer to retirement, your contributions to private accounts will be small. Most of your retirement benefits will come from the traditional system and will be taxed as they are today.

Younger participants will have many years of tax-deferred growth. A greater portion of their retirement income may be made up of distributions from these accounts. This could have a positive affect on their taxes. After 30 years of participation in a private retirement account, assuming an investment return of 7% and contributions made with after-tax money, approximately 65% of each distribution would be taxable. Compared to the 85% of Social Security retirement benefits taxable today, the combination of Social Security and private account distributions would likely generate a lower overall tax liability for future retirees.

The Bottom Line
Workers can expect to pay more in payroll taxes, and future retirees may pay less income tax on their Social Security retirement benefits.