Repealing taxes on Social Security benefits resonates with many workers and retirees, who would receive bigger monthly benefit checks. But there would be substantial downsides, including the acceleration of trust fund depletion and broader policy questions about the progressive nature of the retirement income insurance program.
These dynamics are explored in a new report by Morgan Stanley, led by Monica Guerra, executive director and head of U.S. policy at Morgan Stanley Wealth Management.
As the authors detail, the Trump administration recently proposed ending the taxation of Social Security benefits. For middle- and higher-income retirees who see the majority of their benefits taxed, this would provide larger payments in the near term. However, the experts caution, that’s just one of the likely policy outcomes.
“The proposal could alter expected benefit amounts, impact savings and withdrawal rates, and have notable consequences for future generations’ retirement planning,” the report warns. “Furthermore, policy action could take many forms, and litigation in the courts could produce various outcomes.”
As such, advisors and clients should proceed with caution respecting their benefit calculations as the Social Security tax question is debated in Washington.
Where Social Security Stands
To help understand what’s at stake in the Social Security tax debate, the report spells out where the program currently stands.
The Social Security trust fund used to support the payment of retirement benefits is structurally imbalanced, as the experts recount. The primary explanation, according to the report, is the growing mismatch between the number of retirees drawing benefits and the number of workers paying taxes into the program.
If current policies remain untouched, the combined Social Security trust funds are expected to become insolvent by the end of 2034, at which time expected revenues will no longer cover benefits in full.
Once the trust funds are depleted, payments could decrease by 20% or more. While higher-income retirees with significant assets elsewhere could likely stomach the hit, the effect could be devastating on lower-income retirees who get much or all of their income from the program.
No Taxes on Benefits
Amid this concerning outlook, the authors find, the Trump administration’s proposals to eliminate taxation of Social Security (as well as end taxes on tips and overtime) would likely accelerate the insolvency date if implemented.
This is due both to the loss of tax revenue and to increased benefit outlays. These factors would push the fund’s projected insolvency date forward by as much as three years, or to the end of 2031, according to estimates from the Committee for a Responsible Federal Budget.
“Their calculations suggest the trust fund 10-year cash benefit shortfall would increase by $2.3 trillion, equal to 30% of projected benefits in that time period, with payments after 2031 falling to 70% of the expected benefit without additional funding sources,” the report states.
Payments Would Go Up, for a Time
While trust funds would likely be depleted more rapidly under the “no tax on Social Security” policy, benefits in the near term will increase. For some late-career workers and current retirees, the effect on their overall retirement finances could be surprisingly profound.
Citing data from the Wharton School’s federal budget model research, the report shows that benefits could result in income after taxes increasing by 0.1% to 1.2%, depending on tax bracket, after 10 years. Over time, these seemingly modest increases could notably affect retirement portfolios, the authors note.
To illustrate the point, they conduct a scenario analysis with an individual claiming Social Security with $1 million in retirement portfolio value and a 6% annual spending rate over a 20-year period. A tax-exempt benefit regime for six years, followed by an assumed 30% cut to benefits to adjust to the projected trust fund shortfall, would provide this individual almost $400,000 of additional asset value in a high-tax state like New York and about $300,000 in additional asset value in a low-tax state like Florida.
In both New York and Florida, a depletion of the trust fund by 2034, followed by a reduction of benefits to 80% of the full amount, results in lower returns than scenarios with no tax on Social Security.
Conclusions and Considerations
It is tempting to view the no-tax scenario as an appealing one, the authors note, given the bigger retirement portfolios measured in the projections. But, they warn, the dollar value of the portfolios is just one factor amid a broader set of considerations.
For example, while strong retirement portfolio performance may result from eliminating taxes on Social Security benefits, it is also important to consider how consumer spending affects retirement savings depletion.
“Importantly, consumer spending is variable due to lifestyle, foreseen and unforeseen large expenditures, as well as inflation dynamics — all of which we encourage investors to consider on an annual average basis to encourage sustainability over the long term,” the report says.
Using a high-tax scenario, the authors find that individuals who spend between 4% and 6% of their target retirement portfolio value on an annual basis, compared to individuals who spend 8%, are much less likely to deplete their retirement savings over 20 years — regardless of Social Security benefit tax status. People who spend more would benefit the most from seeing taxes cut on their Social Security benefits, as this would allow them to meet higher spending levels while drawing less from private retirement accounts earlier on.
“While current retirees are well positioned to benefit from Trump’s no tax on Social Security policy proposal, we highlight that trust fund insolvency still looms large and that future generations of Social Security beneficiaries may not experience these gains,” the authors conclude. “Structural imbalance of the fund is not new and will remain a pressing concern regardless of the policy path forward.”
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