Editor's Note: This story originally appeared on SmartAsset.com.
When Social Security benefits increase by an estimated 6% next year to keep pace with inflation, the larger payments may come with a significant caveat for some beneficiaries.
The historic jump in Social Security’s annual Cost of Living Adjustment expected in January could push your income beyond the thresholds that determine your Medicare Part B premiums and how much of your Social Security benefits are subject to income tax.
COLA Definition
The federal government adjusts the amount of Social Security that beneficiaries receive each year in order to keep pace with inflation. This change is known as a cost of living adjustment, or COLA, and it’s intended to preserve the purchasing power of Social Security benefits.
The Social Security Administration calculates its COLA each year by measuring inflation during the third quarter of the prior year. To do this, the government examines the 12-month change in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) and then increases Social Security benefits to match the rate of inflation.
With the price of goods and services soaring in 2021, Social Security beneficiaries could see their payments rise by as much as 6.2% next year, according to the Senior Citizens League. While that sounds like great news, it could mean some beneficiaries will also see their Medicare Part B premiums increase and more of their benefits withheld for taxes.
COLA and Medicare Part B Premiums
Medicare Part B premiums, which cover physician and outpatient services, are deducted from a person’s monthly Social Security check. How much you pay is linked to your income. If your modified adjusted gross income is above a certain amount, you may pay what’s called an income-related monthly adjustment amount.
The monthly premium for single individuals with incomes of $88,000 or less and married couples with $176,000 or less is $148.50 in 2021. For taxpayers who make more, premiums can reach as high as $504.90 per month.
Annual COLAs can catapult a Social Security beneficiary into the next income bracket and result in higher Part B premiums. For instance, a single person with $110,000 in yearly retirement income has $207.90 deducted from his Social Security benefits each month for Part B. But after receiving a 6% bump in Social Security via next year’s COLA, the person will exceed his current income threshold and pay $297 per month in Part B premiums.
Meanwhile, premiums have risen faster than COLA increases in recent decades. According to “The Impact of Inflation on Social Security Benefits” published by the Retirement Research Center at Boston College, Part B premiums jumped by an annual average of 5.9% between 2000 and 2020. Increases in Social Security benefits averaged just 2.2% per year during the same time span.
“The impact of rising Part B premiums would be even greater for high-income individuals, because their premiums constitute a larger share of their Social Security benefits,” Alicia H. Munnell and Patrick Hubbard wrote.
COLA and Taxes
Like Part B premiums, next year’s COLA could have a more significant impact on the way Social Security benefits are taxed than in years prior.
Under current federal law, individuals with between $25,000 and $34,000 in combined gross income pay federal income taxes on up to 50% of their Social Security benefits, while people with over $34,000 in combined gross income will pay federal income taxes on up to 85% of their benefits. Married couples, meanwhile, pay taxes on up to 50% of their combined gross income if it’s between $32,000 and $44,000. Up to 85% of benefits are taxable if a couple’s combined gross income is over $44,000.
However, the Retirement Research Center notes these income thresholds do not increase each year “in response to either wage or price growth,” leaving more and more Social Security beneficiaries to pay taxes on their benefits.
“A personal income tax with unindexed thresholds for benefit taxation means that wage growth and inflation will subject an increasing portion of Social Security benefits to taxation. Taxation further reduces the net benefit that people will receive.”
How to Protect Your Social Security Benefits
Reducing gross income is one of the most common strategies for protecting assets like Social Security benefits from higher tax rates. A qualified charitable distribution from an IRA is one way to do just that.
A qualified charitable deduction is money transferred directly from an IRA to a charity. The contribution is not considered part of your taxable income and can satisfy your required minimum distributions (RMDs). For example, someone who is required to withdraw $20,000 from their IRA can instead simply transfer the money to a qualified charitable organization, lowering their tax bill.
“Using required minimum distributions (RMD) toward charities is a great way to help lower a client’s income especially as the RMD grows,” said Ryan Marshall, a certified financial planner and accredited investment fiduciary at Ela Financial in New Jersey. “Most clients are already donating to charities so instead of the money coming from a client’s checking or savings account, we use the IRA’s RMD to fund their charitable contributions.”
For example, he noted, if a client who’s required to withdraw $30,000 from her IRA finds herself $10,000 over a particular Medicare income threshold, she could make a $10,000 charitable donation directly from her retirement account and avoid paying higher Part B premiums.
“They are making donations anyway,” Marshall noted. “It’s just a matter of how and where they are making the donations.”
Bottom Line
As the price of goods and services continues to increase, the federal government uses an annual cost of living adjustment to ensure Social Security benefits can keep pace.
Next year’s COLA is expected to be the largest increase in decades (6.2%) and could result in larger tax bills and higher Medicare Part B premiums for some Social Security beneficiaries. Reducing your gross income by donating required minimum distributions from an IRA to charity can help mitigate the potential negative impact of next year’s historic COLA.
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