Social Security and Railroad Retirement Benefits were first taxable up to a maximum of 50% of the benefits paid, based on income. The 50% figure was chosen because one-half of the total Social Security contribution is made by the taxpayer and 50% by the employer. This was eventually increased to a maximum of 85% of benefits paid, taking into account the “accrued earnings” on the contributions.
Currently the taxable portion of Social Security and Railroad Retirement benefits is determined using a complicated formula based on taxable and tax-exempt income and filing status. Under this formula it is possible that each additional $1.00 in income could be taxed as $1.85, and 85 cents of each additional $1.00 of tax-exempt municipal interest would be effectively taxed.
And under the current rules, although we say that capital gains and qualified dividends are taxed at a special 0% or 15% tax rate, these items of income can increase the amount of taxable Social Security and Railroad Retirement benefits, so that the effective tax rate is in reality more than 0% and 15%.
In my new Tax Code I would calculate the taxable portion of Social Security and Railroad benefits in the same manner as any other pension or annuity.
I would use the Simplified General Method to allocate the recovery of employee “after tax” contributions to the Social Security system (employee Social Security tax, but not Medicare tax, withholdings) to each monthly check over a period of time based on the age of the recipient when payments began.
If it was determined that the annual recovery of employee Social Security contributions for a retiree was $3,000, and the total Social Security benefits received for the year was $18,000, then $15,000 would be taxed income, regardless of the amount of the taxpayer’s other taxable and tax-exempt income.
Determining the taxable portion of Social Security benefits for individuals who had paid “self-employment tax” over the years may be a bit more complicated. The taxable portion of benefits paid to minor children will also be more complicated to determine. But I expect the SSA software can be adjusted to determine the amount to report in these situations.