By Laurence J. Kotlikoff, Next Avenue
Social Security’s Earnings Test tops my list for our government’s most senseless and personally financially destructive policy. The Earnings Test is a massive tax that isn’t. It’s a tax that’s levied and then secretly returned making no money on balance for the government (as measured on an actuarial present value basis). Its sole purpose is to con Social Security beneficiaries below age 67 into thinking that earning money beyond a di minimis amount will come at a huge loss in current net income as well as lifetime benefits.
Here’s how Social Security describes the Earnings Test. This text appeared in a letter I received in December, 2022. The letter, which announced the system’s 2023 COLA (Cost-of-Living Adjustment) was, I presume, sent to each of Social Security’s 70 million beneficiaries:
Working and Getting Social Security at the Same Time
You can work and still get Social Security benefits. If you are at full retirement age or older, you may keep all your benefits no matter how much you earn … If you are younger than full retirement age at any time in 2023, there is a limit to how much you can earn before we reduce your benefits …
- The 2023 earnings limit for people under full retirement age all year is $21,240. We deduct $1 from your benefits in 2023 for each $2 you earn over $21,240.
- The 2023 earnings limit for people reaching full retirement age in $56,520. We deduct $1 from your benefits in 2023 for each $3 you earn over $56,520 until the month you reach full retirement age.
An Outdated ARF Formula
That’s the entire description. There is no mention that benefits lost to the Earnings Test are fully restored at full retirement age (FRA) in the form of an inflation-adjusted, permanently higher benefit level. This tax rebate is called the Adjustment of the Reduction Factor (ARF). This rebate is meant to leave those hit by the Earnings Test with the same average lifetime benefits calculated on an actuarial present value basis. Actually, the ARF overcompensates for the tax. Why? Because the ARF formula was established years ago when mortality and interest rates were higher.
The ARF’s title is arcane. That’s no accident. It was chosen to keep beneficiaries from learning that the Earnings Test tax, paid in the form of reduced benefits received, would be rebated. The term “benefit reduction” is, itself, tricky. If you take any of Social Security’s benefits early — before your full retirement age — they are reduced in light of the fact that you’ll receive more payments over the rest of your life than if you wait.
But the Earnings Test’s “reduced benefits” represent an additional reduction that kicks in if you not only take benefits early, but earn, prior to full retirement age, more than the Earnings Test’s relevant threshold. Indeed, the Earnings Test’s benefit reduction can be large enough to wipe out all benefits you’d otherwise receive in the years prior to reaching full retirement age. Those lost benefits would be lost for good were it not for the ARF.
Why is Social Security Maintaining Its Con Job?
The Earnings Test and ARF were part of Social Security’s original design. The ostensible goal of the Earnings Test was to keep able-bodied people from taking benefits. i.e., Those who can work don’t need to collect!
But the system’s architects didn’t want to lower lifetime benefits of working beneficiaries. To prevent this outcome, they included the ARF. But in combination, the two provisions simply change the timing — the cash flows — of a working beneficiary’s net benefits, giving them lower (if not zero) benefits before FRA and higher benefits thereafter.
Hence, for early beneficiaries aware of the ARF as well as the Earnings Test, the policy comes down to reducing such beneficiaries’ short-term cash flows. But ARF-aware early beneficiaries who go back to work aren’t likely to be severely cash-flow constrained since they are earning money. Hence, the policy devolved into lying by omission — intentionally not informing early beneficiaries about the ARF. Ostensibly, this would dissuade most abled-bodied older adults who could work from taking benefits.
As for those who took benefits anyway, “Well, too bad if they were dissuaded from working. They are trying to collect benefits when they can still earn money. Shame on them. Let’s make earning more than peanuts appear worthless and con them into not working. But if they work anyway, they must be desperate, so let’s secretly compensate them for lost benefits.”
Those who know the precise twisted logic underlying the con job’s origination are long dead. But by imposing and maintaining the con for decades, Social Security’s has led tens of millions of early beneficiaries to falsely believe that earning more than a pittance is a fool’s errand.
The policy works. Various studies, starting, I believe, with this one I authored in 1978, show that early beneficiaries bunch their earnings just below the earnings-test thresholds — the levels beyond which benefits are “taxed.”
The Pretend Tax’s Authors are Dead, Their Successors Are Alive
Those who established this pretend tax are no longer alive to admit that the Earnings Test plus ARF only matters if you don’t tell people about the ARF, i.e., if you run a con job. But we can ask senior Social Security officials why they continue, year after year, to run this con. Let me do so right now.
Acting Social Security Commissioner, Dr. Kilolo Kijakazi, please explain why you are sending out letters that describe the Earnings Test but not the ARF. Surely you realize that falsely telling a, say, 63-year-old beneficiary who is earning above the minimum wage, that working full time will place them in a roughly 75% tax bracket, once they combine their federal income taxes, FICA taxes, state income taxes, and Earnings Test, is conning them out of earning money and, thereby, lowering their current and future living standard? Are you playing God and deciding that conning early beneficiaries out of working is worth it because it will keep others from taking their benefits early, i.e., at a permanently, actuarially reduced level, foregoing some of the system’s longevity insurance value?
Illustrating the Pretend Tax
Let me illustrate the pretend tax using my company’s Maximize My Social Security software tool. Meet Arthur, a hypothetical age 62, single, Massachusetts resident. Arthur just retired. Check that. He was laid off from his $67,000-paying job. The reason? His company lost a major contract. Short of money, Arthur immediately filed for Social Security. After the reduction for taking his retirement benefit early, Arthur’s annual benefit came to $22,226. His lifetime benefits totaled $861,213.
A week after starting Social Security, Arthur’s boss rang him up. The big client had changed their mind. The contract was back. Could they please unfire Arthur?
Arthur, having spent a week accumulating blisters bowling with his buddies, was desperate to get back to work. But earning $67,000 would, thanks to the Earnings Test, cost Arthur $22,880 in benefits. This is larger than the $22,226 he was receiving, meaning working would cost Arthur every penny of his benefits.
Worse, Arthur would need to pay 15.3% of his earnings in payroll taxes (note: workers effectively pay both the employer and employee halves of the FICA tax), 22% in federal income taxes, 5% in Massachusetts state income taxes, and, effectively, another 6% earnings tax called the Massachusetts sales taxes. (Paying taxes when you use your earnings if fundamentally no different than paying taxes when you receive your earnings.) When Arthur added up all these taxes, he realized he’d be paying almost every penny he made in taxes or lost benefits.
But Arthur had never heard of the ARF? Why? Because Dr. Kilolo Kijakazi can’t figure out that he needs to include this information in bold letters on the Social Security website and in all communications sent to beneficiaries.
Since Maximize My Social Security fully incorporates both the Earnings Test and the ARF, it’s easy to see what happens to Arthur’s benefits if he returns to work until age 67 and starts benefits then. Arthur’s lifetime benefits rise to $1,045,670. That’s a $184,457 increase! The ARF, as mentioned, more than compensates Arthur for the $86,889 in lifetime benefits he loses to the Earnings Test.
But something else is going on. By working five more years, Arthur improves his covered earnings record, which further boosts his annual benefit. Thanks to the ARF and Social Security‘s Recomputation of Benefits, Arthur’s inflation-adjusted annual benefit from working through age 67 is $30,190 — far above the $22,225 if he retires for good at 62.
Our politicians are finally discussing reforming Social Security. Step 1, which they can pass today, is eliminating the Earnings Test. Doing so is a win- win for workers and the government. Yes, Arthur ends up with higher lifetime benefits. Yes, the ARF favors Arthur over Uncle Sam. But this ignores the over $50K in extra FICA and federal income taxes Sam will pay by working through age 67. Plus, the State of Massachusetts will haul in over $35K.
In short, eliminating the Earnings Test is an economic and fiscal no-brainer. What about the concern that doing so will induce more workers to take benefits early and lose the extra longevity insurance from receiving permanently higher benefits by waiting?
There’s a simple answer. Those taking benefits early would have the option to suspend all or a portion of their benefits through FRA, after which they could use the current system that lets you suspend your retirement benefit between FRA and 70.