Some Social Security Beneficiaries Encounter an Unanticipated Challenge in the Upcoming Year
Retirees heavily rely on Social Security, a significant retirement program in the U.S. According to the Center on Budget and Policy Priorities, Social Security has reduced the poverty rate for adults aged 65 and above by about 70%, from an estimated 38.7% without Social Security to 10.2% with it, in 2022.
For over two decades, Gallup's annual surveys have shown that Social Security income is crucial for retirees' financial health. Since 2002, between 80% and 90% of retirees have stated that their monthly Social Security check is a major or minor part of their income, with 88% acknowledging this in 2024. For most elderly workers, the guaranteed payout is essential for making ends meet.
Given its crucial role in seniors' lives, it's no surprise that the announcement of Social Security's cost-of-living adjustment (COLA) is eagerly awaited each year. Despite the 2025 COLA's revelation, some beneficiaries may still be in for an unwelcome surprise in the new year.
The importance of Social Security's COLA
The COLA that's often discussed is a benefit adjustment applied in most years to account for the inflationary pressures that beneficiaries face. For instance, if the price of a typical basket of goods and services purchased by retirees increases by 2%, their benefits would need to rise by 2% as well, in order for them to maintain their purchasing power. Social Security's COLA serves as this annual "raise" intended to keep benefits in line with the prevailing inflation rate.
Prior to 1975, Social Security's COLA was established through special sessions of Congress, with only 11 COLAs passed in the first 34 years of the program's existence. However, when cost-of-living adjustments were introduced, they often resulted in substantial increases, such as the 77% raise in 1950.
Since 1975, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has been used to calculate COLAs on an annual basis. This index, which encompasses more than 200 separate spending categories, is reviewed monthly by the U.S. Bureau of Labor Statistics. Only trailing-12-month readings from the months ending in July, August, and September (i.e., the third quarter) are considered in the COLA calculation. If the average third-quarter CPI-W reading rises in the current year compared to the previous year, inflation has occurred, and benefits will increase in the subsequent year.
A series of above-average COLAs are on the horizon
During the 2010s, Social Security beneficiaries faced several challenging years, with three years of deflation (prices decreasing year over year) and no COLA paid out (2010, 2011, 2016). Additionally, the smallest positive COLA in history was administered in 2017 (0.3%).
However, the past few years have shown a significant shift. Abundant fiscal stimulus during the COVID-19 pandemic has led to a sharp increase in U.S. money supply, resulting in inflation rates not seen in four decades. This has resulted in COLAs of 5.9% in 2022, 8.7% in 2023 (the highest since 1982), and 3.2% in 2024.
While inflation rates are currently decreasing, Social Security's 2025 COLA is still projected to be above its recent average. Over the previous 15 years, the average cost-of-living adjustment has been only 2.3%, yet in 2025, beneficiaries can expect a 2.5% increase in their benefits.
According to the Social Security Administration, a 2.5% COLA would result in an additional $49 per month for the average retired worker, bumping their income to $1,976 in 2025. Similarly, the average disability benefit and survivor benefit payouts would each increase by $38 per month, to an estimated $1,580 and $1,551, respectively, in the upcoming year.
An unexpected challenge for some retirees in 2025
At first glance, it may seem like good news for Social Security's retired-worker beneficiaries in 2025. However, a closer examination reveals that Social Security's 2025 COLA comes with a drawback.
As benefits have increased over time, they have exposed a larger portion of retired workers to federal taxation on their benefits. In fact, a portion of your Social Security check may be subject to federal taxation, as well as state taxes in nine different states.
In 1983, Social Security's reserve assets were almost depleted, leading to the possibility of drastic benefit cuts. Had elected officials not taken action, widespread benefit reductions might have been necessary.
The Amendments to Social Security Act of 1983 gradually elevated the complete retirement age and boosted the tax levies on laborers, while also instituting the imposition of taxes on retirement benefits. Commencing in 1984, up to 50% of benefits could be subject to federal taxation if the prospective earnings (adjusted gross income plus tax-exempt interest plus half of the benefits) of a solitary filer or a pair filing jointly surpassed $25,000 and $32,000, respectively. In 1993, the Clinton administration introduced a second tax bracket, which enabled up to 85% of benefits to be taxed for solitary filers and couples who surpassed $34,000 and $44,000 in respective prospective earnings.
The peculiarity of these prospective earnings thresholds is their inability to adjust for inflation. When the initial tax bracket was introduced four decades back, it was anticipated to apply to merely 10% of all households receiving benefits. However, with Cost-of-Living Adjustments (COLAs) reliably augmenting payouts, an increasingly higher percentage of pensioner households are being subjected to this loathed tax. The 2.5% COLA in 2025 is predicted to expose even more retirees to this detested tax.
Despite the fact that the majority of seniors would appreciate the abolition of taxation on Social Security benefits, the truth remains that this tax isn't going anywhere or being adjusted for inflation following numerous decades. In accordance with the 2024 Social Security Board of Trustees Report, the program is confronting a $23.2 trillion funding shortfall through 2098. Social Security is in dire need of income...and that includes the federal taxation of benefits.
In light of the anticipated 2.5% COLA in 2025, many retirees will see an increase in their Social Security benefits, with the average retired worker receiving an additional $49 per month. However, this increase may also expose more retirees to federal taxation on their benefits, as a larger portion of their income exceeds the fixed tax thresholds that have not been adjusted for inflation since their introduction.
Consequently, even though retirees may welcome the absence of benefit cuts due to Social Security's financial struggles, they must grapple with the continued taxation of their Social Security benefits, which is expected to affect an increasing number of seniors due to annual COLAs and inflation adjustments.
