If the Social Security Administration (SSA) decides to include a COLA in the next year's benefit, they determine how much the increase should be for the following year's payment. Inflation is also a factor in the program's contribution amounts.

In the 1970s, inflation-adjusted Social Security payouts were introduced. It is important to know why and how this COLA was implemented by the Social Security Administration (SSA).

Social Security COLA History

A rise in living expenses did not trigger an automatic increase in Social Security benefits throughout the first four decades of the program's existence. Only after Congress approved a raise through legislation did they change.

However, for many Americans, the cost of living began to soar in the 1970s. As a result of the dollar's decoupling from gold standards, as well as rising oil prices and supply shocks, the United States experienced a decade of extraordinary inflation. Even though rising earnings provided some respite from rising costs, those on fixed incomes, notably the elderly, were particularly hard hit.

The result of all this was a change to the Social Security program by Congress, which allowed benefit amounts to be adjusted in line with inflation. Congress approved the Social Security COLA in 1972, but it didn't take effect until the following year.

Social Security Inflation Bump

Benefits for Social Security recipients have recently received their largest cost-of-living increase in four decades to help offset the blazing rates of inflation we have seen over the past year. Even so, it's possible that after accounting for changes to Medicare premiums and other taxes, this adjustment will be less significant than you expect.

A 5.9 percent boost in Social Security benefits for pensioners this year is a response to the rise in consumer prices that we've witnessed due to the epidemic era. The average benefit will rise by roughly $93 a month, or more than $1,100 a year, based on your 2021 benefit, although the precise amount may vary. It exceeded the previous record-high level for the first time since July 1982.

How Are These Increases Calculated?

The SSA uses data from the previous year's third quarter to modify the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). For example, the CPI-W measures urban wage-earners spending habits on food and beverages, transportation, and healthcare.

For example, in the third quarter, inflation jumped dramatically from 5.4 percent in September to 6.2% in October and 6.8% in November before settling at a record-high 7.0% for 2012. Even this year's exceptionally enormous cost-of-living rise may not feel like much of a benefit if the rate of price increases remains high.

There's also some controversy over whether urban workers' spending habits are a reliable indicator of older citizens' real-world expenses. The government records a separate inflation figure for people over the age of 62, which focuses more on medical care and housing. Congress is debating a plan to move to a more accurate index. For the time being, the CPI-W remains the official measure of cost-of-living adjustments, despite some studies suggesting that CPI-W rises could be significantly bigger.

How The Taxes May Be Affected?

Despite the growing benefits, the IRS standards determining the number of your taxable benefits will remain the same, meaning that more people may be required to pay taxes on their Social Security payments.

Up to 85% of their benefits will be taxed if their annual income exceeds $44,000. There is a $25,000-$34,000 threshold for single filers and any amount over that. Because they haven't been updated since the early 1990s, these limitations may appear low.

What does this imply in real life? A retired couple with $300,000 in tax-deferred assets and a combined Social Security income of $2,599 per month is a perfect retirement scenario. Their combined income would have been $43,188 if they had adopted a simpler version of the 4 percent rule to withdraw from their tax-deferred savings, which had not been adjusted for inflation. Those payments might be taxed as much as 85% if they fall just short of the threshold, meaning up to half of their Social Security income would be taxed.

This year's increase in benefits would send their total income above $45,000 even if they didn't do anything else, placing them at risk of a substantially bigger tax burden.

Of course, this is only a simple example. Tax-free withdrawals are possible for couples who have done advance tax planning and moved some of their tax-deferred funds to an after-tax Roth account. After considering the IRS-mandated minimum withdrawals from their tax-deferred accounts, prudent cash flow management could also assist them in staying below the Social Security tax limits.

There is a lot to learn about Social Security. Talk to your financial advisor if you have questions about how inflation and rising living costs can influence your income plan or tax obligations.