State governments provide a wide array of tax breaks for their elderly residents. Almost every state that levies an income tax allows some form of income tax exemption or credit for citizens over age 65 that is unavailable to non-elderly taxpayers. Most states also provide special property tax breaks to the elderly. Unfortunately, too many of these breaks are poorly-targeted, unsustainable, and unfair. This policy brief surveys federal and state approaches to reducing taxes for older adults and suggests options for designing less costly and better targeted tax breaks.
Federal Income Tax Breaks for Elderly Taxpayers
Federal tax law provides two substantial tax breaks to elderly taxpayers:
- A partial exemption for Social Security benefits: No taxpayers with Social Security income pay tax on every dollar of their benefits. Elderly taxpayers with incomes below $25,000 ($32,000 for married couples) are fully exempt from paying taxes on Social Security benefits. Income for this purpose is adjusted gross income plus half of Social Security benefits. For those with incomes between $25,000 and $34,000 ($32,000 and $44,000 for married couples) up to 50 percent of benefits are taxable and for higher incomes up to 85 percent is subject to tax.
- A larger standard deduction: All married couples can claim a $12,600 standard deduction in 2016 while elderly taxpayers receive an extra $1,250 for each spouse over 65. Single elderly taxpayers also receive an extra deduction.
Most States Offer Additional Elderly Tax Breaks
Most states that levy income taxes go beyond the tax preferences for the elderly inherited from federal income tax rules and allow special elderly-only tax breaks of their own. Many states also provide property tax breaks available only to homeowners (and in some cases renters) over 65. For a list of tax breaks by state, see the chart at the end of the brief.
- All Retirement Income: Three states with a broad-based income tax (Illinois, Mississippi, and Pennsylvania) fully exempt all retirement income from taxation. This includes private and public pensions, Social Security, and annuities.
- Pension Benefits: 36 states with an income tax allow some exemption for private or public pension benefits. These range from fully exempting all pension benefits for adults above a certain age to exempting only a portion of benefits or the benefits earned by specific types of workers, such as military veterans.
- Social Security: 32 states with an income tax exempt all Social Security benefits from tax. Five states tax some Social Security benefits, but provide an exemption that is more generous than what is available at the federal level. Six states tax Social Security benefits using the same exemption rules as the federal government.
- Other Income: Virginia, for example, allows an exemption capped at $12,000 for all sources of income for adults 65 and older with annual income below $50,000 ($75,000 for married couples). A few states exempt interest, dividends, or capital gains income received by seniors.
- Extra Personal Exemption and Standard Deduction: 20 states allow senior citizens an additional personal exemption or exemption credit, allowing these taxpayers to shelter twice as much of their income from tax as non-elderly taxpayers. Seven states allow their senior citizens to claim the higher federal standard deduction.
- Property Tax Reductions: 22 of the 30 states that provide a property tax credit limit the credit’s availability to senior citizens, or provide a more generous version of the credit to older adults. In some states, the credits are calculated based on the relationship between income and property taxes (a circuit breaker) and in others the credits are simply based on age and income. Many states also offer homestead exemptions, which shelter a certain amount of a home’s value from tax, that are larger for senior citizens than for other taxpayers.
Design Issues for Elderly Income Tax Breaks
The goal of reducing taxes for elderly taxpayers is a politically attractive, yet costly, one—and lawmakers in virtually every state have taken steps to achieve it. Providing such tax breaks requires confronting several important design issues that can make the difference between an effective policy and a poorly-targeted and expensive tax giveaway.
First and foremost, there is the question of who should benefit. In many cases, wealthy elderly taxpayers reap the biggest benefits from state income tax breaks designed for older adults. This is especially true in states that fully exempt Social Security or pension income from the tax base. Low- and fixed-income elderly taxpayers are already shielded from owing income taxes on Social Security if states follow the federal rules; if states choose to exempt all Social Security benefits, they spend a lot of money offering a tax break to those who do not need it. In Rhode Island for example, more than half of the benefit of fully exempting Social Security from the state’s income tax flows to the richest 20 percent of taxpayers. Exempting all retirement income is even less targeted with two-thirds or more of the break going to the top 20 percent in Rhode Island.
Given the costs of poorly targeted tax breaks, some states allow elderly exemptions only for low-income seniors. For example, Montana exempts up to $3,980 of pension income, and the exemption is gradually reduced to zero for single taxpayers with incomes over $35,180 ($37,170 for joint filers). Most states, however, extend elderly tax breaks to seniors at all income levels. Imposing income limits helps to target the benefits of pension and other retiree tax breaks to truly needy seniors.
Other considerations include:
- Exemption, deduction, or credit? States can provide income tax breaks through deductions and exemptions, which reduce taxable income, or through credits, which provide a dollar-for-dollar reduction in tax liability. Deductions are usually worth much more to upper-income taxpayers, while credits provide a more equal benefit to taxpayers with varying levels of income.
- What types of income should be eligible for tax breaks? Many state income tax exemptions for elderly taxpayers apply only to particular income sources, such as pension and Social Security benefits, while providing no tax breaks for earned income such as salaries and wages. Special tax breaks for pension benefits shift the cost of funding public services away from older adults who have retired onto working taxpayers—including seniors who remain in the workforce.
- How large an exemption, deduction, or credit? States that provide elderly exemptions usually limit the amount that can be deducted. Arkansas, for example, allows seniors to exempt the first $6,000 of all pension benefits. Yet other states allow much higher caps on deductions; a married Maryland couple over 65 could deduct as much as $58,400 in benefits in 2015. And three states (Illinois, Mississippi and Pennsylvania) completely exempt all pension benefits from income tax while fully taxing seniors’ wages. Imposing a low cap on exemptions for seniors helps to target the benefits of elderly tax breaks to low-income seniors most in need, and makes these exemptions more affordable for state governments.
- Refundable or non-refundable credit? A refundable income tax credit is one that is available even to those who owe little or no income tax. Refundability is important for fixed-income seniors who pay a larger portion of their income in sales and property taxes than in income taxes. Idaho, for example, has a special “grocery tax” credit (available to taxpayers of all ages, but seniors get a higher credit) that is administered through the income tax, and is designed to offset sales taxes on low-income seniors who may owe no income tax. Refundable credits are the best-targeted, and least expensive, way to achieve income tax relief for fixed-income seniors.
Demographic Trends Mean Growing Costs for Elderly Tax Breaks
Poorly targeted tax breaks for the elderly are a costly commitment for many states and long-term demographic changes threaten to make these tax breaks unaffordable in the long-run. Older adults are the fastest growing age demographic in the country. According to the US Census, the population of adults 55 and older grew by more than 30 percent between 2000 and 2010, while the population of those under 55 grew only by 4 percent. This trend is even starker in some states, where the population of older adults has grown by as much as 50 percent in just a decade.
By 2030, almost 20 percent of the US population will be over 65. Over time, this demographic shift will mean that a shrinking pool of workers will be forced to fund tax breaks for an expanding pool of retirees—heightening the need to target these tax breaks appropriately to minimize their cost.
Moreover, while poverty has often been associated with advanced age, a 2014 US Census report found that Americans over 65 are less likely to be poor than people in their prime working years, further exacerbating the mismatch between the tax breaks offered and needs within the population. Since the 1990s, the poverty rate for the elderly has been steady at 10 percent, recently decreasing to 8.8 percent in 2014, while the overall share of Americans living in poverty has risen to 13.5 percent. Trends such as rising income inequality and single-parent household formation have eroded the middle class, further weakening the pool of workers that finance tax breaks for the elderly.
Elderly Tax Breaks: Matching Rhetoric with Reality
Few demographic groups receive more attention from state lawmakers than fixed-income seniors. There is a virtual consensus among elected officials that retirees should not be “taxed out of their homes,” for example. Yet state income tax breaks for elderly taxpayers typically grant the lion’s share of their benefits to better-off elderly taxpayers. These poorly targeted tax breaks shift the cost of funding public services towards non-elderly taxpayers, many of whom are worse off than the seniors benefiting from the tax breaks. Retooling elderly tax breaks to better target the neediest seniors will help states, in the long run, to achieve a fairer and more sustainable tax system.
See the accompanying chart for a state-by-state overview of tax breaks for elderly taxpayers as well as age demographic trends.