Tax Reform Could Take Variety of Paths

“The Congress faces an array of policy choices as it confronts the challenges posed by the amount of federal debt held by the public—which has more than doubled relative to the size of the economy since 2007.”

By John Manganaro | December 27, 2016
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The large annual budget deficits projected under current law have many tax experts contemplating ways the federal government could bring in additional revenue; the Congressional Budget Office (CBO) has published a paper exploring more than 100 potential avenues for reform.

The extensive research paper estimates the budgetary effects of each approach and highlights some of the advantages and disadvantages of each, including options that would impact the tax treatment of assets allocated pre-tax for retirement.

One such option suggested is to “tax Social Security and Railroad Retirement benefits in the same way that distributions from defined benefit pensions are taxed.” According to CBO researchers, “under current law, less than 30% of the benefits paid by the Social Security and Railroad Retirement programs are subject to the federal income tax. Recipients with income below a specified threshold pay no taxes on those benefits. Most recipients fall into that category, which constitutes the first tier of a three-tiered tax structure.”

The researchers further note that if the sum of this group’s adjusted gross income, their nontaxable interest income, and one-half of their Social Security and Tier I Railroad Retirement benefits exceeds $25,000 (for single taxpayers) or $32,000 (for couples who file jointly), up to 50% of the benefits are taxed. Above a higher threshold—$34,000 for single filers and $44,000 for joint filers—as much as 85 percent of the benefits are taxed.

The paper continues: “By contrast, distributions from defined benefit plans are taxable except for the portion that represents the recovery of an employee’s basis—that is, his or her after-tax contributions to the plan. In the year that distributions begin, the recipient determines the percentage of each year’s payment that is considered to be the nontaxable recovery of previous after-tax contributions, based on the cumulative amount of those contributions and projections of his or her life expectancy. Once the recipient has recovered his or her entire basis tax-free, all subsequent pension distributions are fully taxed … Distributions from traditional defined contribution plans and from individual retirement accounts, to the extent that they are funded by after-tax contributions, are also taxed on amounts exceeding the basis.”

CBO suggests this tax reform approach would treat the Social Security and Railroad Retirement programs in the same way that defined benefit pensions are treated—by defining a basis and taxing only those benefits that exceed that amount. For employed individuals, the basis would be the payroll taxes they paid out of after-tax income to support those programs (but not the equal amount that employers paid on their workers’ behalf).

“Under this option, revenues would increase by $423 billion from 2017 through 2026,” the paper suggests. “This option also has drawbacks. It would have the greatest impact on people with the lowest income: People with income below $44,000, including some who depend solely on Social Security or Railroad Retirement for their support, would see their taxes increase by the greatest percentage. In addition, raising taxes on Social Security and Railroad Retirement benefits would be equivalent to reducing those benefits and could be construed as violating the implicit promises of those programs.”

NEXT: Various other tax reforms suggested