What to Know About Social Security’s 2023 COLA

Last week, the Social Security Administration (SSA) announced its 2023 cost of living adjustment, or COLA, would be 8.7%, the highest adjustment since 1981. The increase, which is based on the Consumer Price Index, affects around 70 million Americans, providing more than a $140 monthly increase for the average Social Security recipient. Regular Social Security beneficiaries can expect to see the change in their January 2023 check, with the timing dependent upon the recipient’s birthdate.

Tax Implications

Coupled with a slight decrease in 2023 Medicare premiums, this may seem like great news to help you cope with inflation. For some retirees, however, it won’t be quite enough to offset higher expenses, forcing some to withdraw more from their retirement accounts. The increase could also push some retirees into a higher tax bracket. That’s because the taxation of Social Security benefits isn’t indexed to inflation – it stays the same. Consequently, as your benefits adjust higher for inflation, you may cross into a higher tax bracket.

To understand how the COLA could affect your taxes, it’s important to understand how the IRS taxes Social Security benefits. If your total income, including wages, interests, dividends, retirement account distributions and pensions, is more than $25,000 for an individual or $32,000 for a married couple filing jointly, you’ll need to pay federal taxes. According to the SSA:

• If you file an individual return and your combined income is between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits. Above $34,000, up to 85% of your benefits may be taxable.
• If you and your spouse file a joint return and your combined income is between $32,000 and $44,000, you may owe income tax on up to 50% of your benefits. Above $44,000, up to 85% of your benefits may be taxable.

Married couples filing separate tax returns will probably also pay taxes on their benefits.

How can you avoid paying more tax as a result of the COLA? While every situation is different, one option is to minimize, if possible, the amount you withdraw from your traditional IRA or 401(k). (You should still take any required minimum distributions, or RMDs, as required.) Traditional IRAs and 401(k)s are taxed as ordinary income according to your marginal tax bracket.

Other options? This isn’t an all-inclusive list, but you could consider withdrawing money from a brokerage account, for which you would pay capital gains tax on investments held longer than a year. The capital gains tax rate is lower than the income tax rate. You could also consider taking withdrawals from your Roth IRA or Roth 401(k), or even your Health Savings Account (HSA), none of which is subject to federal income tax under certain conditions. For example, you must use your HSA money for qualified health expenses, and Roth IRAs have a “five-year rule” that says earnings withdrawals are not tax-free unless it’s been at least five years since you first contributed to your Roth IRA.

Getting the withdrawal “formula” exactly right can be difficult, so be sure to consult your financial advisor and/or tax professional before you begin making withdrawals, and keep a long-term perspective in mind.

If you aren’t collecting Social Security benefits yet but are tempted by the prospect of a higher COLA in 2023, you may want to talk to your advisor about claiming strategies. You may find that it still makes the most sense to wait until you are at your full retirement age (FRA), or to delay taking benefits until age 70. That’s because for every year you delay beyond your FRA, your benefit increases by 8%.

Although the COLA may help you stretch your budget during inflationary times, it pays to take a holistic view of your goals, retirement income needs, and tax situation. Our Savant advisors and tax specialists can help you decide what steps to take to maximize your COLA.