How Was COLA Created?
Social Security benefits have been adjusted for inflation since 1972. This came as a result of several laws passed by Congress as part of the Social Security Amendments of 1972. Initially, there was a need for a new law every time Congress wanted to adjust payments, which created a significant burden to maintain benefits at the levels of high inflation at that time.
Starting in 1975, COLAs became automatic. This shift occurred when Congress tied COLA to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), allowing Social Security payments to increase as prices rose without the need for new legislation. When CPI-W increases by at least 3%, it triggers the need for a COLA, but this method did not last long. In the mid-1980s, inflation rates were below normal levels, leading to several years without a COLA under the 3% threshold, so in 1986, Congress decided to eliminate it.
In the current system, when inflation rises, Social Security payments will increase to reflect the rising costs. COLAs are now made based on the increase in CPI-Ws. Specifically, COLAs are based on the rise in CPI-W from the third quarter of the previous year to the third quarter of the current year, as measured by the U.S. Department of Labor.
What Is the Purpose of COLA?
COLA is designed to protect against inflation, but the goal may not be as you imagine. The objective of COLA is not to raise the standard of living for people receiving Social Security payments, but to maintain the purchasing power of income benefits over time. Understanding inflation over a year or two does not significantly impact the amount you will see in your monthly benefit checks. However, over a span of 20, 30, or 40 years, or the lifetime that a healthy person might expect in retirement, it can have a significant effect. The value of the dollar can change a lot from decade to decade, and although benefit checks may look the same over time, their value will decrease. In other words, COLA attempts to maintain the status quo. This feature has the most impact during periods of high inflation.
For example, if you retire and the current inflation rate is 2%, your income will need to increase by about 50% from age 65 to 85 just to maintain your standard of living. If inflation is 4%, that income will need to more than double over those 20 years to keep your standard of living steady. Your dollar’s purchasing power, or its market value, decreases when inflation rises. If your benefit check remains the same amount from year to year, it will buy less and less over time. COLA aims to prevent the erosion of your money’s value over time. It reflects Congress’s belief that retirees should be able to afford the same amounts of goods and services with their income as they did in previous years.
How Is COLA Calculated Each Year?
The value of the increase you will see in your monthly check is based on CPI-W, which measures the change in the price of a basket of consumer goods. The CPI-W uses a sample person working in an urban job and earning wages as a model for obtaining baseline numbers. It then measures how price changes will affect a segment of the typical workforce.
There is a very specific formula that drives COLA results. A COLA occurs if the average CPI-W from the third quarter of the previous year to the same quarter of the current year increases by at least 0.1%. If CPI-W decreases or increases by less than 0.05% (a number that is rounded to zero), there is no COLA and thus no change in Social Security benefits.
If
CPI-W revealed a change within the given range, and Congress may decide to implement a new COLA. New COLAs are often announced during the month of October. Any adjustments will apply to benefits paid in January of the following year.
How have COLAs changed over time?
Historically, the increase in COLA for social security has varied. The maximum taxable amount for social security has also changed, which is the highest amount subject to social security tax. Over the past few decades, annual COLA increases have ranged from 14.3% (as was the case in 1980, during a time of high inflation) to 0%, as seen in 2010, 2011, and 2016.
In 2022, the COLA increase was 5.9%, and the maximum amount of taxable earnings in 2021 was $147,000. In 2023, the COLA will see a significant increase of 8.7%, with the maximum taxable earnings set at $160,200.
Does COLA affect income limits for the IRS?
The limits on social security retirement earnings also adjust with COLAs. Some individuals choose to receive social security benefits before reaching full retirement age, as defined by the IRS. They are taxed on half of their earnings above the annually set minimum threshold. In 2021, this threshold was $18,960, or $1,580 per month. In 2022, the threshold is $19,560, or $1,630 per month.
The IRS uses your “full retirement age” when estimating your tax liability on annual income. This age changes when you retire, but only if you are of a certain age. For social security, this age varies based on your birth year: it is 66 years for those born from 1943 to 1954, and 66 years and 2 months for those born in 1955.
For individuals who reach the year they will turn full retirement age, one dollar is taxed for every three dollars earned above the second limit if they reach it before their birthday. This amount was $50,520 in 2021, and $51,960 in 2022. Starting from the birthday month when they reach full retirement age, the earnings limits no longer apply.
Source: https://www.thebalancemoney.com/social-security-and-cost-of-living-adjustments-cola-2894591
Leave a Reply