Should we rethink how we tax Social Security benefits?

Taxation of retirement income is an important issue. People with significant 401(k) holdings are going to owe the government a meaningful portion of their pile in taxes.

In the process of calculating how large that tax burden might be, it was necessary to review the taxation of Social Security benefits.

The taxation of benefits was introduced in the 1983 Amendments to the Social Security Act. The consensus at the time was that the tax treatment of Social Security benefits should match that of private pensions. Under the rules for defined benefit pensions — the predominant form of employer-sponsored plan at the time — workers are taxed on their benefits net of any after-tax contributions they made during their careers. Since only the nominal value of the worker’s contributions are netted out, the netting process produced very small tax savings. Social Security actuaries estimated that, for most beneficiaries, this approach would result in over 90% of benefits being taxed. To avoid overtaxing anyone, the share of Social Security benefits subject to taxation was set at 85%.