What 8.7% Social Security COLA for 2023 means for taxes on benefits
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Retirees who rely on Social Security benefits for income will get some relief from record high inflation when an 8.7% cost-of-living adjustment kicks in next year.
But two factors — the size of Medicare Part B premiums and taxes on benefits — may offset just how much bigger those monthly checks will be in 2023.
The good news is that the standard monthly premium for Medicare Part B, which covers outpatient and medical coverage, is set to go down by 3% next year, to $164.90 from the current rate of $170.10. Because those premiums are typically deducted directly from benefit checks, a lower rate will make it possible for more beneficiaries will see the bump from the cost-of-living adjustment, or COLA.
However, the higher COLA could prompt some beneficiaries to get bumped into a higher tax bracket.
The record-high COLA is “great” for retirees, as they grapple with higher prices on everything from rent to food to gas, according to Brian Vosberg, a certified financial planner and enrolled agent who is president of Vosberg Wealth in Glendora, California.
“While they’re excited to see the increase coming, they’re not really envisioning what the impact can be from a tax standpoint, and then the tax standpoint then trickles down to their other expenses in retirement,” Vosberg said.
How Social Security benefits are taxed
Social Security benefits are taxed based on a formula known as “combined” or “provisional” income.
That is calculated by taking your adjusted gross income and adding non-taxable interest and half of your Social Security benefits.
Taxes on Social Security benefits apply to single taxpayers starting with $25,000 in combined income, and married taxpayers starting with $32,000 in combined income.
Individuals with between $25,000 and $34,000 in combined income pay tax on up to 50% of their benefits. The same goes for married couples earning between $32,000 and $44,000.
For individuals with more than $34,000 in combined income and couples with over $44,000, up to 85% of their Social Security benefits may be taxed.
Because the thresholds are not adjusted for wage growth or inflation, over time that has pushed more Social Security beneficiaries to pay taxes on their benefits, according to the Center for Retirement Research at Boston College.
When taxes on benefits were first introduced in 1983, just 8% of eligible families paid taxes on benefits. In 2021, that had climbed to an estimated 56%, according to the Center for Retirement Research. With moderate inflation, that was projected to increase to 58% in 2030.
“If inflation rises faster, Social Security benefits will be even higher in nominal dollars and more families will pay on more benefits — further reducing the net benefit,” wrote Alicia Munnell, director of the Center for Retirement Research, and research associate Patrick Hubbard.
How beneficiaries’ taxes may increase in 2023
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Increases in Social Security income next year may not give beneficiaries the ability to ramp up their retirement withdrawals without facing tax consequences, according to Joe Elsasser, a CFP and founder and president of Covisum, a provider of Social Security claiming software.
For example, with a roughly 7% increase in tax brackets, beneficiaries may think they can take 7% more from their individual retirement account next year and have the same tax results.
“That’s not the case, because of a larger amount of Social Security becoming taxable,” Elsasser said.
However, there may be room for some beneficiaries to increase their retirement withdrawals while still not incurring a tax liability on their benefits, according to Elsasser.
For example, a married couple who are both over 65 with $35,000 in Social Security benefits this year may take $23,967 in withdrawals in 2022 and pay no federal income tax, according to Elsasser’s calculations.
Don’t wait to see your CPA by April 15; it’s too late.
president of Vosberg Wealth
In 2023, that couple’s Social Security benefit would increase to $38,045 with the COLA, and the amount they would withdraw may go up to $24,793, Elsasser said.
If the couple’s Social Security benefits instead were $60,000, then they could withdraw $18,703 with no tax, which in 2023 would go up to $65,220 in benefits and slightly less — $18,585 — in possible withdrawals.
To be sure, the results will vary based on an individual’s or couple’s unique financial situation.
Beneficiaries who have the choice of where to withdraw their supplemental income should re-evaluate that choice every year to get the best tax results, Elsasser said.
What to do to minimize your tax bite
Experts say the goal is to identify a blend of retirement income that works for your personal situation and keeps your total or combined income under certain limits.
If you’re have money saved both in retirement and other accounts, you may be able to come up with an estimate using tax software and varying the amount of IRA withdrawals, Elsasser said.
“But this is definitely the area of tax-focused financial planners,” Elsasser said.
Whatever your budget is, you should shoot to figure out where that income is going to come from by Jan. 1, according to Vosberg.
“Don’t wait to see your CPA by April 15; it’s too late,” Vosberg said. “The income you’ve already received is pretty much set in stone.”
Beneficiaries who continue with the status quo of retirement withdrawals and bank interest may find themselves paying more taxes at the end of next year if they’re not proactive, he said.
To minimize your tax bite, try taking withdrawals from non-taxable income sources, like Roth individual retirement accounts, Vosberg said.
As Federal Reserve rate hikes go into effect, it would be wise to also pay attention to how much interest you may be making on savings, including money market accounts and certificates of deposit, that can increase your income, he said.
Keep in mind that having higher income due to the Social Security COLA may also affect how much you pay for health-care coverage, Vosberg said.
Those who have not yet turned 65 and are covered through Affordable Care Act insurance may see their subsidy or premium credits go down. Those who are on Medicare could have higher surcharges for Medicare Parts B and D.