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This Social Security Rule Should Have the Rich Jumping for Joy in 2021
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This Social Security Rule Should Have the Rich Jumping for Joy in 2021

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For the more than 64 million people currently receiving a Social Security benefit, we've entered the most important time of the year. That's because the next couple of months will determine how much of a "raise," if any, beneficiaries will receive in 2021.

It's the most important time of the year for Social Security's 64 million-plus beneficiaries

Since 1975, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has served as Social Security's inflationary tether. The CPI-W measures the changes in price for a large basket of goods and services.

Image source: Getty Images.

To determine Social Security's annual cost-of-living adjustment (COLA), only readings from the third quarter (July through September) are considered. Thus, the average CPI-W reading from the third quarter of the current year is compared to the average CPI-W reading from the third quarter of the previous year. If this figure has risen from one year to the next (signifying inflation), Social Security's beneficiaries will be getting a raise that's commensurate with the percentage increase and rounded to the nearest tenth of a percent.

In 42 of the past 45 years, Social Security beneficiaries have received a "raise" to help them keep up with inflation.

But this wasn't the case in 2010, 2011, or 2016. In the event that the CPI-W shows prices have fallen on a year-over-year basis (i.e., deflation), Social Security's COLA is 0%. Essentially, benefits remain static from one year to the next. Thankfully, monthly benefits can't decline due to deflation.

With July now in the books, there are two months left that matter in determining Social Security's COLA for 2021. However, it isn't looking promising for beneficiaries that they'll be seeing a bump up in their payouts come January.

According to June inflation data from the U.S. Bureau of Labor Statistics, the CPI-W has increased by a mere 0.5% over the trailing 12-month period. The somewhat similar Consumer Price Index for All Urban Consumers (CPI-U) shows a double-digit percentage decline for all things energy over the past 12 months, which substantive declines in transportation services, apparel, and used cars and trucks. Though it's possible COLA could be positive for 2021, it's looking probable that next year will be fourth time in 46 years where beneficiaries don't receive a COLA.

Image source: Getty Images.

No COLA in 2021 would be great news for high-income earners

However, Social Security's COLA determination affects more than just what its 64 million-plus beneficiaries take home each month. The fact is that a 0% COLA could have high-income earners jumping for joy.

In a typical year, the National Average Wage Index (NAWI) -- a measure of wage trends in the U.S. used by the Social Security Administration -- will increase. The year-over-year percentage increase in the NAWI is what's used to determine the annual increase in the maximum taxable earnings cap associated with the 12.4% payroll tax on earned income.

For example, the 2018 NAWI was 3.6% higher than the previous year. Therefore, the maximum taxable earnings cap rose from $132,900 last year to $137,700, as of 2020. This $4,800 bump represents an increase of (drum roll) 3.6%.

But there's an interesting Social Security rule that comes into play when the program's COLA is 0%. In years where deflation occurs, the maximum taxable earnings cap remains unchanged from one year to the next. This holds true even if the NAWI is positive -- and according to Social Security Administration projections, the NAWI was expected to rise 3.1% for the upcoming year's calculation.

In other words, 94% of working Americans won't earn $137,700 in 2020, and will therefore be paying into Social Security, via the payroll tax, on every dollar they make. It's the remaining 6% who earn more than $137,700 that are required to pay more each year when the NAWI leads to an increase in the payroll tax cap. But if there's no COLA in 2021, there won't be a payroll tax cap increase, either. This means the rich will be able to hang onto more of their earned income, at least for one year.

Image source: Getty Images.

Why isn't Social Security taxing the rich more?

You're now probably asking yourself why this loophole exists in the first place. In essence, why aren't the well-to-do being taxed more to strengthen the Social Security program?

The answer to this question lies with yet another Social Security rule.

You see, there's a maximum monthly payout allowable at full retirement age ($3,011 in 2020). Although this maximum payout is often adjusted on an annual basis, the fact is that the maximum taxable earnings cap exists because there's also a cap on how much a retired worker can receive each month. It doesn't make sense to tax millions of dollars in earned income if the most an individual can expect to receive is $3,011 a month from Social Security.

Additionally, even with the American public in favor of taxing high-income earners more, amending the Social Security Act isn't easy. Doing so requires 60 votes in the Senate, and there hasn't been a true supermajority in over 40 years. To amend the Social Security Act would require bipartisan support; and Republican lawmakers have already stated their objection to increasing taxes on the wealthy to generate additional revenue.

While 2021 could be another bad year for Social Security recipients on the loss of purchasing power front, it might be a great year for high-income workers.

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