Social Security Inflation Bump: What Does It Mean?
After a year of painful increases in prices in shops and at the pump, retirees are due for some pleasant news. Whether the recent announcement that Social Security benefits are getting their biggest bump since the early '80s, while Medicare Part B premiums will fall slightly, counts as pleasant news depends on your point of view.
The pessimist might say these adjustments will kick in too long after historically high levels of inflation started wreaking havoc on everyone's finances—a case of the proverbial barn door finally closing after the horse rampaged through the grocery store. The optimist might take comfort in the notion that a benefits boost could at least take some of the dread out of next year's shopping trips.
"Social Security benefits generally do keep up with inflation, though there is a lag," says Rob Williams, managing director for financial planning, retirement income and wealth management at the Schwab Center for Financial Research. "At the same time, the average retiree's expenses generally shrink over time, which can complement those higher benefits."
Here, we'll look at how these increases work and what that mean for taxes and other issues.
The Social Security Administration (SSA) will increase monthly benefits by 8.7% for 2023 to restore some of retirees' spending power after more than a year of resurgent inflation. The increase will boost the average benefit by about $140 a month, or more than $1,680 a year, though the actual amount will vary depending on your 2022 benefit. The increase comes after a similar boost of 5.9% for 2022 benefits and will be the largest such increase since 1981.
The first payments at this higher level will go out in January 2023.
How are these increases calculated?
The SSA bases these adjustments on the Bureau of Labor Statistics' Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), using data for the third quarter of the previous year. In other words, the 2023 benefits will adjust in line with average inflation rate during the July 2022-September 2022 period. The CPI-W tracks the spending patterns of urban wage earners, covering items such as housing, transportation, food and beverages, and medical care.
Some retirees may feel like the coming increase is a case of too-little-too-late after the blistering inflation of this summer—the change in the CPI-W hit 9.3% in May and topped out at 9.8% in June before falling over the subsequent three months, when Social Security benefits were calculated—but it's worth recalling that the increase is permanent. If inflation rates ease in the coming months in response to the Federal Reserve's aggressive rate increases, retirees will still have those higher benefits.
There's also some debate over whether the way urban workers spend their money is an appropriate analog for spending by seniors. The government actually tracks a separate inflation measure for Americans age 62 and older called CPI-E, which gives more weight to medical care and housing costs, and Congress is considering a bill to make the switch to a more representative index. Some studies have shown that cost-of-living increases using that measure could be slightly larger, but for now CPI-W remains the official source for cost-of-living adjustments.
What about Medicare?
Meanwhile, the standard Medicare Part B premium will fall slightly to $164.90 per month in 2023 from $170.10 this year. Medicare Part B premiums are generally deducted from Social Security benefits, so the slight dip will mean retirees can benefit more from the benefits bump.
How might this affect taxes?
The government isn't just adjusting Social Security benefits. Income tax brackets will also adjust higher to account for inflation (though, the change there is based on yet another inflation gauge called the chained CPI-U). That should come as some relief to retirees with taxable income or gains from investments who practice tax bracket harvesting and worry the higher benefits could scramble their withdrawal and income plans.
That said, some retirees with lower incomes could find themselves paying more in tax, as the IRS rules governing the portion of benefits subject to taxes will stay the same. As a result, some people could find that while the SSA boosts their benefits, the IRS takes more of those benefits away.
As things stand now, if a couple filing jointly has "combined income"—which covers adjusted gross income, plus half of one's Social Security benefits, plus non-taxable interest income—of $32,000 to $44,000, then up to half of their benefits will be taxed at their regular income tax rate. If their income is above $44,000, up to 85% of their benefits will be taxed. (For single filers, the numbers are $25,000-$34,000, and anything above $34,000.) If these limits seem low, that's because they haven't been adjusted since the early '90s.
Imagine the recent market drops leave a newly retired couple with $260,000 in tax-deferred savings and combined monthly Social Security benefits of $2,734 (according to the SSA, that is the average amount for couples in 2022). If they used a simplified version of the 4% rule to draw from their tax-deferred savings, their starting combined income would be $43,208. That would mean up to half of their Social Security benefits would be taxed, as they would still be just shy of line beyond which the taxable portion would rise to as much as 85%.
However, even if they changed nothing else, the benefits increase for 2023 would boost their total income above $46,000, putting them over that line and exposing them to a potentially much larger tax bill.
"If anything, these changes are a reminder that retirees' incomes aren't truly fixed," Rob says. "Social Security benefits can change from year to year, and retirees can and should adjust their spending as their situation and the broader economic and financial environment evolve."
Building some flexibility into your retirement plans can help. For example, a couple that had done some advance tax planning and converted a portion of their tax-deferred savings to an after-tax Roth account could draw from those savings tax-free, assuming they met the holding requirements. Careful management of their cash flow after accounting for IRS-mandated required minimum distributions from their tax-deferred accounts could also help them stay below the Social Security tax thresholds.
Social Security can be a complex topic. If you have questions about how inflation and cost-of-living increases might affect your income strategy or taxes, talk with your financial advisor.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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