Most of the tax relief resulting from the elimination of taxes on Social Security income will not go to low-income seniors who are living off of their monthly Social Security check, but to relatively high income households that are likely to have significant sources of other income in addition to Social Security. In fact, approximately three-quarters of the tax reduction resulting from the full exemption of Social Security benefits from the state income tax will go to the wealthiest one-third of Minnesota households.
The first thing to understand about the taxation of Social Security income in Minnesota is that the Social Security of low-income households is already exempt from the state income tax. The extent to which Social Security income is taxed depends on a household’s “provisional income,” which equals adjusted gross income other than Social Security, plus one-half of Social Security benefits, plus tax-exempt interest. For married couples with provisional income below $32,000 ($25,000 for singles), all Social Security income is already fully tax exempt; for couples with provisional income between $32,000 and $44,000 ($25,000 to $34,000 for singles), up to half of Social Security income is taxable; and for couples with provisional income above $44,000 ($34,000 for singles), up to 85 percent of Social Security income is taxable.
Because provisional income excludes one-half of Social Security income, the gross income of a household can comfortably exceed $32,000 before any tax on Social Security income is due. The following example is based on a married couple with Social Security income of $25,000 (about the average for married couples) and no other income except for those categories included in provisional income. For such a couple, gross income (in this example, provisional income plus one-half of Social Security income) would have to exceed $44,500 before any tax would be due on the $25,000 of Social Security income. The graph below shows the portion of Social Security income that would be taxable for this couple, assuming various levels of gross income.
Under these conditions, a married couple with gross income of less than $44,500 would derive no benefit from a full exemption of all Social Security income because none of their Social Security income is taxable under current law. The benefit of a full exemption of Social Security would be small for couples with gross income slightly above $44,500, but would steadily increase as income grows. A couple with gross income in excess of $74,400 would see a reduction of $21,250 (85 percent of $25,000) in taxable income. This example illustrates how the bulk of tax relief resulting from the full exemption of Social Security income from state taxes would accrue to high-income households, with relatively little going to middle-income households and none going to low-income households.
Based on a Minnesota Department of Revenue (MDOR) analysis of 2012 data as summarized in a recent Minnesota House Research Department background paper, only about 32 percent of Social Security income is currently taxable due to the existing Social Security exemption and other provisions of state law that reduce taxable income. The Social Security income that is taxable goes primarily to higher income households; thus, these higher income households will be the primary beneficiaries of the complete exemption of all Social Security income.
For example, none of the reduction in taxable income resulting from the full exemption of Social Security will accrue to the 40 percent of Minnesota households with annual income below $33,334. (These findings are based on 2012 data from the 2015 Minnesota Tax Incidence Study that uses a broad definition of annual income that includes most taxable and non-taxable money income.) The next 30 percent of households with annual income from $33,334 to $73,485 will receive 26.5 percent of the aggregate reduction in taxable income resulting from the full Social Security exemption. Nearly three-quarters (73.5 percent) of the reduction in taxable income will go to the 30 percent of Minnesota households with incomes in excess of $73,485.
A further dive into the numbers reveals the absurdity of the claim that the full exemption of Social Security from the state income tax will benefit low-income households that derive all of their income from Social Security. Because provisional income includes only half of Social Security income, a married couple that is exclusively dependent on Social Security would need to have Social Security income in excess of $64,000 before the $32,000 provisional income threshold is reached. Thus, such a household derives no benefit from any additional exemption of Social Security income, because none of their income is taxed currently. Taxpayers with provisional income high enough to pay taxes on their Social Security almost certainly have income from other sources, such as an IRA or pension; it is unlikely that anyone with income exclusively from Social Security pays any Minnesota income tax.
The analysis above focuses on the reduction in taxable income. The actual reduction in taxes resulting from a full Social Security exemption is even more skewed in favor of high-income households because the marginal income tax rate of high-income households is greater than that of lower income households because of Minnesota’s progressive income tax rate structure. Consequently, the tax reduction resulting from each one dollar reduction in taxable Social Security income will be greater for high-income households than for middle-income households.
This conclusion is confirmed by additional MDOR data cited in the House Research background paper. For example, based on tax year 2013 data, the average tax reduction resulting from the full Social Security exemption for households with adjusted gross incomes from $250,000 to $499,999 would be $1,916—5.6 times greater than the $291 tax reduction for households with adjusted gross incomes below $50,000. An incidence analysis of MDOR data shows that the full exemption of Social Security benefits is significantly regressive and will increase the overall regressivity of Minnesota’s state and local tax system.
Because the Social Security benefits of low-income households are already tax exempt, the exemption of the remainder of Social Security benefits will direct tax relief primarily to high-income households, with a relatively thin slice of the remaining relief going to middle-income households and nothing going to low-income households. Part two of this series will examine other consequences of fully exempting Social Security benefits from the state income tax.