Let’s talk today about the recently announced cost of living adjustment (COLA) to Social Security. After much speculation and anticipation, it was recently officially announced that benefits will increase by 8.7% in 2023. This comes on the heels of a 5.9% increase for 2022, following paltry bumps for many years prior. I don’t think we’re revealing anything most of you aren’t already aware of, at least those that are collecting Social Security or approaching the age to do so. What we want to do today is talk about the ramifications of this so that you can make well-informed decisions in light of this historic increase. As seen in the chart below, this is the largest increase since 1982, in turn making it the largest increase any current retiree has experienced.
What this means to your monthly benefit checks is pretty clear. They will go up – and will be further accented by the slight decrease in Medicare Part B premiums. However, there are some natural questions and considerations that come with this reality. Let’s look at them now.
Don’t rush to file – If you are eligible for benefits but have not yet elected to start receiving them, it’s natural to wonder if you should hurry off to the local Social Security office to commence your benefits and thus take advantage of this COLA increase. The answer is NO! If you are 62 or older, this increase will accrue to your future benefits, even if they are years down the road (Before age 62, an individual’s future benefits are adjusted for inflation through a different methodology). Your decision on when to start should remain one that is based on your personal and family circumstances, such as your age, life expectancy, cash flow needs and marital status, as well as some other commonly overlooked nuances.
Be careful with taxes – While Social Security benefits are adjusted for inflation, as are many provisions of the tax code (such as the standard deduction), one tax code provision that is not adjusted is the threshold for taxation of Social Security benefits. As you may know, your Social Security benefits are taxed differently depending on your total income. As little as 0% can be taxed and as much as 85%, with some people taxed on 50% of their benefits. Unlike many elements of the tax code, these are not graduated thresholds. Instead, once you are $1 above the threshold, the percentage of your benefits that are taxed increases dramatically. One concern with this upcoming COLA increase is that it will bump many taxpayers above their current threshold, resulting in a net decrease in take-home benefits on an after-tax basis. Confused? Let’s look at an example. We’ll start by looking at the official language from the IRS regarding how this is all calculated, and then we’ll look at a real-life example.
How much is taxed?
Your benefits may be taxable if the total of (1) one-half of your benefits, plus (2) all of your other income, including tax-exempt interest, is greater than the base amount for your filing status. Adding 1 and 2 gets you to your “combined income,” which is referenced below.
An example:
Married couple, each receiving Social Security benefits
Total gross annual benefits (both spouses): $35,000
Required Minimum Distributions from retirement accounts: $25,000
Tax-exempt interest: $1,000
Let’s compute this couple’s “combined income”:
(1) 50% of gross SS benefits = $17,500
(2) All other income = $26,000
Combined income = $43,500
Because this combined income falls between $32,000 and $44,000, only 50% Social Security benefits are subject to taxation.
Now, let’s layer on an 8.7% COLA to their SS benefits, while keeping all other aspects of their income the same. In this case, their income looks like this:
Total gross annual benefits (both spouses): $38,045
Required Minimum Distributions from retirement accounts: $25,000
Tax-exempt interest: $1,000
Let’s compute this couple’s “combined income”:
(1) 50% of gross SS benefits = $19,022
(2) All other income = $26,000
Combined income = $45,022
You can see that their combined income now exceeds $44,000, translating to 85% of their benefits being taxed rather than 50% as before (a $14,838 increase in taxable income in our example). Let’s look at the implications of this. If you run the numbers, you find out that their tax bill in 2023 will increase by $1,377 over 2022, even when factoring in the new standard deduction and tax tables (which were significantly adjusted for inflation, helping to offset some of issue). This meaningfully eats into that 8.7% benefit increase, reducing it to 4.8%. Don’t get me wrong, we all love a nearly 5% pay bump, but we would all love 8.7% even more. In real dollar terms, the couple in our example netted a pay bump of $1,668 rather than the headline increase of $3,045. That’s a decrease ~$115/mo. For those interested, here are the calcs:
If you are still working – Many know that claiming SS benefits prior to your full retirement age (FRA) while still working can result in reductions to your monthly benefits. With this recent COLA, the SSA also increased the earnings limit for workers who are younger than their FRA to $21,240 (from $19,560 currently) (they deduct $1 from benefits for each $2 earned over $21,240) The earnings limit for people who reach their FRA in 2023 will increase to $56,520 (from $51,960 currently) (they deduct $1 from benefits for each $3 earned over $56,520 until the month you reach your FRA). As before, there remains no limit on earnings for workers who are "full" retirement age or older for the entire year. What does this all mean? It means that if you are still working but have not yet reached your FRA, you may now find yourself in a position where it makes sense to start claiming SS when it may not have previously. As with all of this, this requires some further examination, and we invite you to speak with us to see what makes the most sense for your personal situation.
Wrapping it up! - We are excited about this most recent cost of living adjustment. It will make a meaningful difference in the lives of most retirees, especially in the face of seemingly relentless inflationary pressures. We hope this bulletin gave you a quick glimpse into important considerations as you think about what it may mean for you. On the tax front, it’s important to note we presented a simplified example for illustrative purposes. Some careful consideration of your tax picture can mitigate (and even eliminate) to the potential negative ramifications that we presented here. As always, let this be an invitation to consult with us to understand how this increase in benefits impacts your financial plan and how to make the most of it. We’re here to help!