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How Inflation Affects Social Security

how inflation affects social security

If you’ve had to buy anything lately, you’ve probably noticed that just about everything is more expensive now than it was this time last year. It’s not just you — inflation has caused prices to rise across the board. But it’s about more than the costs of goods and services.

Inflation has a way of extending beyond the price tag, including impacting the overall health of the system and the individuals who receive benefits.

The health of the Social Security system

Social Security is one of these areas where the impact of inflation isn’t immediately obvious. However, it affects Social Security by:

  • Decreasing benefits to individuals (like you!)
  • Increasing the rate money leaves the fund, leading to future benefit cuts

There’s no way to know if the recent impact is a burst of inflation caused by supply and demand or if it will stay this way. But it can lower benefits for retirees and damage the health and longevity of the Social Security system.

The Social Security Administration manages the Social Security benefits program. Funds are kept in a trust fund, and the Social Security Trustees issue a yearly report that addresses the longevity of the fund. 

When you read news headlines that say the trust fund is projected to be depleted in 2033, the Trustees’ report is their source. Of course, the Trustees arrive at this forecast by estimating multiple demographics and economic assumptions — so there’s no way to know for sure this will be the result. But it’s their best guess.

Cost of living increases

Every year, by law, Social Security recipients are eligible for a cost of living adjustment (COLA). The annual adjustment increases can help beneficiaries like you keep up with rising prices, and they’re based on price inflation. 

Specifically, it’s based on a measurement known as the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W for short. If inflation moves up, benefits increase. If inflation moves higher than their forecast, the system needs more money to pay benefits than originally forecasted. 

If Social Security takes more money to pay benefits, the trust fund balance will decline faster than expected. This brings us to the forecast of the Social Security Trustees. If you look at the most recent report, their long-term assumption is 2.4%. 

But suppose inflation continues at a higher rate than forecasted. In that case, you can look for the upcoming Trustees reports to begin reflecting that the trust fund will be depleted at an earlier date — and benefit cuts will be mandatory (unless the laws are changed). 

Health care inflation

Another important impact of inflation to consider is health care inflation and how it can affect your Social Security. Medicare premiums are deducted from your Social Security benefits. If Medicare premiums increase, your benefits decrease.

According to data, Social Security benefits have gone up an average of 2.19% annually since 1981. But the actual cost of living adjustment has been 2.83%. This means your benefits increase by the amount of inflation, leaving you in a neutral position where your purchasing power is still the same, but it’s reduced slightly due to health care inflation.

Taxes and inflation

Social Security benefits can be counted as taxable income, and inflation can make it worse. In 1984, only 8% of recipients paid taxes on their Social Security income. But now, that number is almost 50% — and the number of retirees that pay taxes on their Social Security income is projected to increase in the years to come:

  • More than $40 billion in taxes was collected from Social Security benefits in 2020
  • An expected $94 billion will be collected by 2029

Here’s why: The income thresholds that trigger taxes have not been updated since benefits became taxable. They’re still frozen at the same levels they were when the bill was passed, and they’re likely to stay that way. As income levels grow due to inflation, an increasing number of people will be pushed into this tax net.

What can you do about Social Security inflation?

Unfortunately, you probably can’t change the law. But you can develop a plan to reduce its impact.

When evaluating whether your Social Security benefits are taxable, distributions from a Roth IRA or Roth 401(k) are not considered. You may earn an unlimited amount from these sources yet avoid paying Social Security taxes. If you don’t have either of these types of accounts, consider opening one or converting an existing account to a Roth. 

You might also need to receive income from your retirement savings first and defer Social Security benefits. As a result, you could get a larger percentage of your retirement income from Social Security, lowering your entire taxable income.

Qualifying charitable distributions are an option once you reach the age of 70 1/2. This strategy is effective if you regularly donate to your church or another non-profit organization.

Have a plan to combat Social Security inflation

The most important thing to realize is that filing for Social Security is not a DIY project. It isn’t an easy task. Working with a financial professional can help you develop a step-by-step strategy. For example, instead of focusing on maximizing Social Security benefits, your focus should be on optimizing your benefits. 

Every filing strategy must be compatible with your financial life. For help developing a plan to optimize your Social Security benefits, contact my team to discuss your options.

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