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What’s Up With the Social Security ‘Donut Hole’?

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What You Need to Know

  • Democrats have proposed extending the payroll tax to high earners.
  • The plan would create a tax “donut hole” similar to those seen in other federal entitlement programs.
  • If such a law passes, higher-income people would get less back for their taxes paid compared with lower-income people.

When Congressional Democrats, supported by President Joe Biden, unveiled their proposal for shoring up the health of the Social Security program under a framework called “Social Security 2100: A Sacred Trust,” the financial planning industry immediately took notice.

In particular, many policy observers keyed in on the fact that the plan would create a payroll tax “donut hole” similar to those seen in other federal entitlement programs.

The donut hole terminology is an informal way of referring to the wage levels that would not be subject to additional Social Security FICA taxes under dueling proposals put forward by Biden and key Democratic lawmakers including Rep. John Larson, D-Conn., and Sen. Bernie Sanders, I-Vt.

Both proposals take a similar approach to address Social Security’s sizable projected revenue shortfall, which will see the key federal entitlement program’s trust funds run short of asset reserves in the 2034 to 2035 time range. The Democratic lawmakers argue this shortfall is due in no small part to the fact that payroll taxes are not collected on an individual’s wages over $142,800.

Larson’s legislation, which mirrors the approach endorsed by Biden, would reapply the payroll tax to wages above $400,000, “so the wealthy pay the same rate as someone earning $50,000 a year.” Sander’s proposal, on the other hand, would set the taxable wage level significantly lower, at $250,000.

Under both proposals, however, there would remain a sizable range of wage levels at which taxpayers would continue to generate higher levels of Social Security payments without a higher level of income taxation.

Likewise, under both proposals, those whose wages are high enough to retrigger the payment of the Social Security FICA taxes would see their overall tax burden go up without a commensurate increase in anticipated Social Security benefits.

Points of Political Concern

Speaking last week with ThinkAdvisor, Richard Johnson, a senior fellow in the Income and Benefits Policy Center at the Urban Institute, says the proposals would indeed help to address the Social Security solvency issue by directing more revenue toward the highly popular program.

However, Johnson worries the creation of a Social Security donut hole, and the general reinstatement of the FICA taxes for higher-wage earners who would not receive an increase in future payments, would potentially be problematic from a political perspective.

Johnson’s concern is that, because higher-income people would get less for their taxes paid compared with lower-income people, it could make the program a lot less attractive to higher-income people.

“Today, Social Security is so popular in large part because everyone feels they have a stake in the system,” Johnson says. “But if it starts to be seen only as a lower-income program, that support can erode.”

Johnson and others note that the donut hole “issue” would actually be temporary under the Democratic proposals, as the gap would gradually disappear over time. That is because the wage cap (currently $147,000) is adjusted upward every year according to wage inflation rates. Therefore, at some point, the level would “catch” the wage level at which FICA is reimposed, and there would be no more donut hole.

A Non-Issue for Most Wealth Clients

While attention-grabbing from a tax policy perspective, this potential donut hole issue does not seem to be resonating among financial advisors and their clients who are in the wage ranges that would be impacted by the proposals, which face a challenging legislative outlook in the current closely divided Congress.

In the experience of one wealth manager, Jay Zigmont, founder of Childfree Wealth, clients have many other pressing points of concerns, from the market’s machinations to broader concerns about tax issues, such that he is having few if any conversations about the Democratic proposals.

“When clients have a $150,000 to $400,000 in annual income, Social Security is rarely a focus of the discussion,” he points out. “Younger clients in their 40s or earlier often assume Social Security won’t be there for them in the future.”

When he builds portfolio models for younger clients, in fact, Zigmont tends to discount any anticipated Social Security benefit by 25%, “to be realistic.”

“At the same time, younger clients are planning to put off claiming until 70 and look at Social Security as a nice bonus if it exists, but not a core of their retirement plan,” he explains.

On the other hand, Zigmont says, the raising of the cap on Social Security taxes will have a direct impact on his clients, but the question becomes one of if the clients will get a return on those taxes.

Broader Social Security Considerations

Stepping back, Johnsons points to a key reason why Social Security is in such dire straits in the first place. When Congress last addressed Social Security’s financing problems, back in 1983, the payroll tax rate covered 90% of Americans’ earnings. Today it covers only 83%.

“That is mainly because there has been so much growth in the top end of the earnings distribution,” Johnson says.

To address this problem without creating a donut hole situation, Johnson advocates for a more straightforward approach of increasing the $142,800 tax max to $250,000 today. He would also propose that this wage level be set to automatically grow based on average earnings growth.

“And I would probably reduce benefits a bit for higher-income people,” he concludes.


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