Today, the Social Security Administration announced that benefits payable in December 2008 would be increased 5.8 percent beginning January 1, 2009. This cost-of-living-adjustment (COLA)-- the largest in 26 years--is an important reminder that keeping pace with inflation is one of the attributes that makes Social Security benefits such a unique source of income. (The other is that the payments continue for life.) Higher inflation raises two other issues, however, that diminish the impact of the COLA. The first issue pertains to Medicare Part B premiums, which are deducted automatically from Social Security benefits. To the extent that premium costs rise faster than the COLA, the net benefit will not keep pace with inflation. Historically, premiums have gone up much faster than the COLA, although this year is an exception as premiums for 2009 will be unchanged from their current level. The second issue pertains to taxation under the personal income tax. Because the thresholds ($25,000 for single taxpayers and $32,000 for joint returns) above which taxes are levied are not adjusted for wage growth or even for inflation, rising benefit levels mean that taxation reaches further and further down the income distribution. This brief explores the interaction of inflation and Social Security benefits. The first section describes the nature of the cost-of-living adjustment. The second section looks at the interaction of Medicare premiums and the cost-of-living adjustment. The third section explores how inflation affects the taxation of benefits. The final section concludes. The overall finding is that, while the inflation adjustment in Social Security is extremely valuable, the rise in Medicare premiums and the extension of taxation under the personal income tax mitigate the ability of beneficiaries to maintain their purchasing power. This erosion of retiree purchasing power is serious given that virtually all other sources of retirement income have no inflation protection at all.
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