States Should Target Senior Tax Breaks Only to Those Who Need Them, Free up Funds for Investments

By 2030, 1 in 5 Americans will be over 65, and this growing elderly population will stretch state budgets thin not just with their health care and other needs, but with the expensive tax breaks that every state provides seniors.

By 2030, 1 in 5 Americans will be over 65,^[1] and this growing elderly population will stretch state budgets thin not just with their health care and other needs, but with the expensive tax breaks that every state provides seniors. These breaks cost states 7 percent of state income taxes on average in 2013, a figure that will only rise.^[2] Based on growth in population and personal income, the cost of these tax breaks is now approximately $27 billion a year and will more than double by 2030.^[3] A large share of these costly breaks go to higher-income seniors who need them the least. States should reduce this expense by better targeting relief to seniors with low incomes.

The senior tax breaks are poorly targeted because of their design: most states provide them regardless of the recipient’s income or savings. In particular, exemptions for retirement income such as pensions benefit those higher up the income scale more. As a result, these state policies favor those fortunate enough to receive pensions or annuities — either through a defined benefit plan or a contribution-based plan like a 401(k) — and whose jobs pay enough for them to save for retirement. They also favor those who do not need to continue to work past the traditional retirement age in order to support themselves and their families. These state tax preferences are widespread:

• Some 28 states and the District of Columbia completely exempt Social Security income from their income tax, regardless of the tax filer’s income and wealth;
• 26 states either fully or partially exempt income from non-governmental private retirement accounts such as pensions from taxation;
• All but six states give additional personal income tax exemptions, standard deductions, or credits based on age; and
• Many states assist local governments with the costs of age-based property tax reduction programs; 21 states offer homestead exemptions (which exempt a flat amount of home value from property tax) or credits targeted to the elderly. An additional five states give local governments the option of providing these exemptions.

One justification for these tax breaks is that seniors live on low, sometimes fixed incomes, while the costs that they face, especially for health care and housing, continue to grow. But states first established many of these preferences decades ago, when poverty among the U.S. elderly was much more widespread. In 1970, some 25 percent of this over-65 population had below-poverty income, hence states’ attempts to relieve their tax obligations. Since then, Social Security and Supplemental Security Income (SSI) coverage has expanded, and today, only 9 percent of the elderly are poor.^[4] But the distribution of income among seniors has become more lopsided. Inequality among seniors in the United States is higher than in any Organisation for Economic Co-operation and Development country other than Chile and Mexico and is growing with each generation.^[5]

These tax breaks reinforce unequal distributions of income and wealth, with some groups facing particularly high barriers to accumulating savings and other assets. For example, many Black and Hispanic families have faced long-standing employment and housing discrimination that have made it difficult to build savings for each generation and invest in the future of the next. As a result, such families’ wealth generally is far less than that of white families.^[6] People of color are also less likely to be covered by a defined benefit pension plan and are much less likely to have retirement savings than white households of the same age and income.^[7] As a result, many longstanding state tax preferences for seniors now benefit taxpayers with much better ability to pay taxes than lower-income households.

To raise the revenue needed to support services for seniors and others now and in the future, states can instead target senior tax breaks to those who need them most, by means-testing and/or raising age eligibility of tax exemptions for seniors and retirees, expanding state Earned Income Tax Credits to seniors, providing property tax relief through “circuit-breakers” (which base payment amounts on affordability), and making state tax systems less upside-down in general.

It’s crucial that states consider revenue challenges along with the spending challenges that the aging of the population will bring. And they should do so now, before the full impact of baby-boom retirements hits and the tax preferences’ cost begins to rise rapidly. (We describe political considerations behind taking such steps in the box, “Designing Change to Increase Chances of Adoption.”)

Financial Outlook Improved for Many in Aging Population, Others Face Barriers

The U.S. population is aging as medical advances have increased life expectancy and as baby boomers move beyond middle age. Nationally, the elderly proportion of the population is projected to grow from 16 percent in 2017 to 19 percent by 2030, likely affecting all states. At the time of the last decennial census in 2010, elderly residents made up more than 17 percent of the total population in only one state (Florida); by 2030, all but five states and the District of Columbia will be in this category. (See Figure 1 and Appendix Table 1.)

The last four decades have seen a significant improvement in U.S. senior citizens’ financial well-being. In the 1960s and 1970s, when many states adopted tax preferences for seniors, elder poverty was a much larger problem. In 1970, more than 1 in 4 elderly Americans had below-poverty incomes; that’s down to less than 1 in 10 today.^[8] (See Figure 2.) Because age is no longer so strongly correlated with poverty, states should target tax relief by income.

While a smaller share of seniors live in poverty than in the past, many still struggle to get by. Seniors who have spent their lives working hard, raising a family, and contributing to their communities deserve time to relax with family and friends and focus on interests other than work such as volunteering, sports, creating, or traveling. But this ideal is not within the reach of many.

Most workers are left largely on their own to accumulate savings and assets to fund their retirement beyond what Social Security will provide. The share of private-sector jobs with retirement accounts such as defined benefit pensions or employer-sponsored plans such as 401(k)s has declined substantially since at least the 1980s,^[9] and individuals with retirement accounts are more likely to have moderate to high incomes. Taxpayers with income over $75,000 receive some two-thirds of federally taxable retirement account income.^[10] In addition, workers of color are much less likely have a job that provides retirement benefits — either pensions or 401(k)s. Only 54 percent of Black and Asian workers and 38 percent of Latinx workers are in jobs with a retirement plan, compared to 62 percent of white workers.^[11] Some 47 percent of white senior households receive some retirement account income, compared to 30 percent or fewer of senior households of color.^[12] (See Figure 3.)

Today’s retirees spent their working years in a time of rapidly growing income and wealth inequality. With the lion’s share of income going to the minority of people at the top, low- and moderate-income families face barriers to setting aside a nest egg for retirement.

Some groups face particularly high barriers to accumulating savings and other assets. For example, Black and Hispanic families have faced long-standing employment and housing discrimination that have made it difficult for each generation to build savings and invest in the future of the next.^[13] As a result, the median net worth of white families is ten times that of Black families and eight times that of Latinx families.^[14]

Younger, Wealthier Seniors Get State Tax Breaks Better Targeted Elsewhere

Lower poverty rates and improved health among seniors raise questions about whether states should not only implement means-testing for their senior tax preferences, but also change the age of eligibility, which most states set at 60 or 65. Some 8.2 percent of Americans age 65 to 74 are poor, compared to 10.6 percent for those 75 and over. While people are living longer and older Americans are healthier and more active than in the past — the share of Americans age 65 and older reporting excellent or very good health increased from 42 percent to 48 percent between 2000 and 2014, for example^[15] — health declines the longer people live. “Poor physical functioning is being increasingly compressed in the period just before death,” according to a 2013 paper from the National Bureau of Economic Research.^[16]

Giving additional tax breaks to younger, wealthier seniors who don’t need them strains state budgets, especially given the other programs and services that state budgets must fund, including for the elderly. For example, states provide on average 47 percent of the funding for the Medicaid program, which pays for the vast majority of long-term care in this country and bears a portion of the prescription drug costs for low-income elderly people. States also will have to finance retirement accounts and health care for a growing number of retired state employees. In addition, states and localities provide public amenities like transit systems, libraries, and parks to make a secure, comfortable retirement more widely available. Elderly-related costs borne by state and local governments for other programs ranging from special transportation to social services will also increase.

Existing Senior Tax Preferences

States provide tax reductions for seniors by fully or partially exempting Social Security and income from retirement accounts such as pensions from state income tax; offering income tax exemptions, standard deductions, or credits based on age; and providing age-based property tax reduction programs. In every state with an income tax, seniors pay less on average than other taxpayers with equivalent incomes, though this varies significantly by state. Table 1 shows the percentage that the income tax liability of elderly taxpayers is of that of non-elderly taxpayers with the same amount of income.^[17] For example, the income tax liability of the elderly taxpayers in Pennsylvania is half of that of otherwise comparable non-elderly taxpayers.

In six states – Georgia, Michigan, Mississippi, South Carolina, Kentucky, and Pennsylvania – senior taxes are less than half of what taxpayers under 65 with similar incomes pay. In only nine states with broad-based income taxes^[18] and the District of Columbia, meanwhile, are senior taxes at least 80 percent of the amount owed by taxpayers under 65.

Social Security income. Social Security payments receive some form of special treatment in every state with a personal income tax. Some 28 states and the District of Columbia fully exempt such payments from their income tax regardless of the taxpayer’s income. (See Figure 4 and Table 3.)

This is a vestige of the full exemptions that Social Security income enjoyed from federal and state taxation until the mid-1980s. At that time, as part of an initiative to restore Social Security’s finances and due to many seniors’ improved economic status, the federal government began to tax a portion of recipients’ benefits above a specified income level. Under current federal law, Social Security payments are fully exempt from federal income tax for single taxpayers with incomes below $25,000 and for married taxpayers with incomes below $32,000.^[19] The federal government taxes 50 percent of the benefits of individuals with incomes between $25,000 and $34,000 and couples with incomes between $32,000 and $44,000. It taxes 85 percent of the benefits for individuals with incomes over $34,000 and couples with incomes over $44,000.

Most states failed to change their treatment of Social Security income when the federal government did, and maintained their full exemption. Only six states — Minnesota, New Mexico, North Dakota, Utah, Vermont, and West Virginia — currently follow the federal provisions.^[20] Seven states — Colorado, Connecticut, Kansas, Missouri, Montana, Nebraska, and Rhode Island — tax some Social Security income using a different formula.

Pensions and other retirement income. As people near and pass retirement age, their income sources change significantly. For those age 55 to 65, wages and salaries make up over three-fourths of their income. For those 65 and over, wage and salary income declines to 36 percent of income and Social Security and income from retirement accounts make up half of their income.^[21] Social Security alone accounts for one-third of the income of people 65 and older.^[22]

There are two major types of employment-based pension plans: defined benefit plans and defined contribution plans.

Under defined benefit plans, employers promise a specific regular payment to the employee in retirement. The employer contributes the amount necessary over the work life of the employee to pay the benefits after retirement. These contributions are tax deductible for the employer at the time they are made. And for federal tax purposes, the pension payments that employees receive in retirement are taxable.

Under defined contribution plans, the employee has access to a savings account that is funded through employee contributions and in many cases also through contributions by an employer. The contributions to the plans are usually made with pre-tax dollars; neither the employee nor the employer pays tax on the funds contributed. The income the plan earns also is not taxable while it remains in the account. Withdrawals from defined contribution plans are fully taxable for federal tax purposes. Traditional IRAs that allow tax-free deposits operate in the same manner as defined-contribution pension plans, as do various plans for self-employed individuals.^[23]

These types of plans are called tax-deferred, because the tax on the contributions and earnings is not payable until funds are withdrawn. The tax deferral provides a benefit because the employee can accumulate more funds in the account than if the contributions and earnings were taxed annually. In addition, most people have lower income after retirement than they did while they were working and may be in a lower federal tax bracket at the time they withdraw the funds and thus pay less tax on the funds when they are withdrawn.

The federal tax treatment of pension contributions provides a significant benefit to taxpayers and is intended as an incentive to encourage retirement savings. It makes little sense for states to provide still more generous treatment of retirement income, on top of the federal tax benefits. But a number of states exempt some or all retirement account income from tax — both when it is deposited and when it is withdrawn.

All except seven states plus the District of Columbia with an income tax exempt some or all retirement account income for former government employees, which we refer to as public retirement account income, from their tax.^[24] An argument could be made to treat public and private retirement account income somewhat differently, as some states do, and to exempt some public retirement account income, since it is the state or localities themselves that make these payments. Lower taxes may have been a substitute for higher wages in the past, for example. But more than half the states also extend the preferential treatment to private retirement account income. (See Figure 5 and Appendix Table 3.)

Three states — Illinois, Mississippi, and Pennsylvania — exclude all private and public retirement account income from taxable income. Other states only partially tax income from retirement accounts from private jobs. In states with partial exemptions, the amount exempted varies widely but is substantial. Sixteen states — Arkansas, Colorado, Delaware, Georgia, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Missouri, New Jersey, New York, Oklahoma, Rhode Island, and South Carolina — exempt more than $5,000 of public and/or private retirement account income. In most states these exemptions are available to taxpayers without regard to ability to pay. Only seven states — Missouri, Montana, New Jersey, Ohio, Oregon, Utah, and Wisconsin — limit these exemptions to taxpayers with income below specified levels.

Other income tax preferences. Additional personal exemptions or a higher standard deduction based on age are other common forms of special tax treatment. All but six states with an income tax offer an expanded exemption or credit based on age.^[25] (See Figure 6 and Appendix Table 4.) The most common forms are an additional personal exemption or credit or a higher standard deduction for taxpayers over 65. The amounts of the added exemptions average approximately $1,200 for one taxpayer and $2,400 for two taxpayers. The exemptions generally are not limited to low-income taxpayers. Most states that offer higher standard deductions for those over 65 use the federal definition of taxable income, which reflects the application of a standard deduction that is $1,600 higher for single taxpayers over 65, and $2,600 higher for joint returns.

These design choices affect whether low- or moderate-income taxpayers are most likely to benefit. Because the standard deduction does not benefit those who itemize their deductions — generally higher-income taxpayers — the higher standard deduction is more targeted to lower- and middle-income taxpayers than are the additional personal exemptions. Other states offer credits to seniors ranging from $15 to $236. Of the three main types of senior tax breaks, added exemptions or standard deductions provide a proportionately greater benefit to low-income taxpayers than the exemptions for retirement income or Social Security, but they are generally smaller.^[26]

A few states offer substantial exemptions of certain types of income to seniors, usually on top of the exemptions or credits above. For example, Michigan exempts $11,495 (for single filers) and $22,991 (for joint filers) in interest, dividends, and capital gains income for seniors over 73. Virginia exempts $12,000 of income from any source for taxpayers 80 and older. Similarly, West Virginia exempts up to $8,000 in income for taxpayers 65 and older, without any income limit on who can use the exemption.

Some states also offer credits that equal a portion of the means-tested federal elderly tax credit, which is only available to low-income taxpayers who receive little or no income from Social Security.^[27]

Property tax preferences. Separate from income tax preferences, many states offer property tax preferences for seniors. Property tax reductions for seniors often take the form of homestead exemptions or credits that reduce the amount of property taxes owed. While the property tax is primarily a local tax, homestead exemptions can have a significant impact on state budgets. In some cases, states provide aid payments to local governments to compensate for the costs of the property tax exemptions. Even in states without these aid payments, the erosion of the local property tax base puts pressure on state governments to fill in the gap and assist localities in funding schools and other important local services.

All but 13 states offer some form of homestead exemption or credit program. (See Appendix Table 5.) Of these, 20 offer programs targeted to seniors. Of the 20, eight have senior-only programs while the others offer additional, more generous homestead exemptions or credits to seniors. Some states limit these programs to taxpayers with incomes below a specific level but more often they open them to all taxpayers regardless of income.

One way to provide property tax help more targeted to those in need is to offer a property tax circuit-breaker credit. See the box, “Types of Property Tax Credits and Exemptions.”

How Much Do These Preferences Cost the States?

Individual states have collected some information on these preferences’ costs in their tax expenditure reports but many states do not have information on the full cost. A recent study estimated the cost of these breaks in each state and found that on average, preferential tax breaks for seniors reduced state income tax collections by 7 percent in 2013.^[28] Based on growth in population and personal income, the current price of these tax breaks is approximately $27 billion a year and will more than double by 2030. The cost varies significantly by state. (See Table 2.)

For example, in Georgia, which fully exempts Social Security income from taxation and offers retirement account income exemptions as well as a higher standard deduction based on age, the preferences cost approximately 12.2 percent of the state’s income tax collections ($1.6 billion).

In contrast, the cost is relatively small in states that offer few preferences or target them by income, such as Connecticut, where the breaks equaled 3.5 percent of income tax collections ($310 million). But Connecticut’s cost will grow as the state recently expanded its senior tax preferences.

In Maryland, which has a moderate level of preferences, the cost is approximately 6.5 percent of income tax collections ($670 million).

Are Existing Senior Preferences Reaching Their Intended Targets?

One justification for these tax preferences is that seniors live on low, sometimes fixed incomes while their costs, especially for health care and housing, continue to grow. But states enacted many of the breaks decades ago when the senior poverty rate was much higher. And even as poverty has declined among seniors, income and wealth inequality has grown. A study of Medicare recipients found that half of all recipients had incomes below $26,200, while 5 percent had incomes above $100,000 and 1 percent had incomes over $182,900. ^[29]

The divide between the amount of savings that Medicare recipients have accumulated is even more stark. One quarter of recipients had savings of less than $14,550, while the top 5 percent had savings of more than $1.4 million and the top 1 percent over $4 million.^[30] Because many senior tax breaks are not means-tested, a significant share of what states spend on them is directed to high-income taxpayers with the means to pay taxes.

Added exemptions for seniors benefit taxpayers regardless of their income, but in most states they benefit high-income seniors more than low-income ones, unless they also include specific income limits. There are several reasons for that:

• In states with graduated rate structures — ones where the tax rate increases with income — the exemptions’ value depends on the tax rate that the taxpayer pays on each additional dollar of income. Added exemptions provide a greater benefit to higher-income taxpayers because their marginal tax rates are higher, reducing taxes the most for high-income taxpayers who have the means to pay them.

• Exempting retirement account income disproportionately benefits higher-income households. Families with higher incomes, through wages and salaries or returns on stocks and the like, tend to receive more retirement income. Higher salaries translate into higher Social Security and pension payments. Higher incomes also make it possible to accumulate savings in 401(k) and other retirement accounts. So the dollar value of a full exemption for income from these sources is much greater for higher-income families, which are also more likely to be able to take advantage of partial exemptions.

• Income tax exemptions for seniors don’t benefit taxpayers with income too low to owe state income tax, unlike, say, refundable tax credits, which give taxpayers a partial or full cash refund when the credit amount exceeds their tax liability. It used to be much more common for taxpayers with below-poverty incomes at any age to be subject to state income tax, but now most states exempt low-income taxpayers from it, so only seniors who would otherwise owe tax benefit from the retirement income exemptions. For example, Colorado exempts married couples with no children from its income tax if their income is below 146 percent of the poverty line; as a result, the state’s generous exemption for retirement account income goes only to seniors above this threshold.

  Retirement accounts and Social Security make up only about 38 percent of income for the highest-income fifth of elderly (those with incomes of about $72,000 and above), compared to 84 percent of income for the lowest fifth (those with incomes below $13,500), according to the 2014 Consumer Expenditure Survey. (See Figure 7.) Even though low-income seniors depend the most on Social Security, they benefit the least from state exemptions on this income. The federal government already exempts Social Security income from taxation for low- and moderate-income taxpayers. All states at least follow this federal treatment. The states that go further and fully exempt Social Security income are only benefitting taxpayers who are subject to the federal tax — often people of substantial means who have built up assets over time.

Reducing Senior Tax Breaks Will Not Harm a State’s Economy

Another often-used argument for retaining or creating tax breaks for seniors is that they improve a state’s economy by causing retirees and elderly people to stay in the state or by encouraging them to move there. But there’s no credible evidence to support this claim. State taxes have only a small effect, if any, on the residence decisions of the elderly, recent studies have found. ^[31] On the whole, after their working years, residents move from a state to retire in warmer areas or in locales with lower housing costs.

Other, earlier research has similarly concluded that the correlation between state taxation and seniors’ decisions on where to live is small, at most. Economist Karen Smith Conway, the leading academic expert on this issue,^[32] has with different colleagues found that elderly people who choose to move exhibit only a slight preference for states without income or estate taxes, and that the presence of these taxes does not drive elderly people out of the states levying them. Even these relationships, however, are often not statistically significant or uniform across various measures of tax levels. In summarizing her findings, Conway said, “Put simply, state tax policies toward the elderly have changed substantially while elderly migration patterns have not. . . . Our results, as well as the consistently low rate of elderly interstate migration, should give pause to those who justify offering state tax breaks to the elderly as an effective way to attract and retain the elderly.”^[33] She concluded, “Our results are overwhelming in their failure to reveal any consistent effect of state tax policies on elderly migration across state lines.”^[34]

A 2004 study of the wealthiest elderly — those who file federal estate tax returns — reached similar conclusions. While the researchers found that high personal income taxes reduced the number of federal estate tax returns filed in the state, the effect was not consistent for different models and was relatively small.^[35]

Rather, state reductions in income tax revenue can result in cuts to state services such as education and transportation which boost a state’s economy.^[36] That would likely do more harm to a state’s future economic growth than any small benefit that might come from a tax break for seniors.

Ways to Better Target Tax Breaks to Seniors Who Need Them

States can address these large and growing revenue losses while still providing assistance to seniors in need, for instance by including income limits or tests as part of existing tax reduction programs, or making sure that these limits or tests are part of any new senior tax preferences. Or, states could replace these exemptions and credits with ones much more targeted by income.

For example:

• More states could tax a portion of Social Security benefits when the recipient’s total income exceeds a specified amount — as the federal government does — rather than completely exempting such income from taxation. Six states use the same income limits as the federal government for determining whether to tax Social Security benefits, and another seven states partially tax such income using different income limits. Other states should follow suit.
• States that offer exemptions for income from retirement accounts from private- or public-sector jobs could phase them out at a specific income level or only offer them to taxpayers with incomes below a certain level. For example, the District of Columbia eliminated its retirement account income exemption in 2014, and in 2003 Virginia scaled its exemption back by phasing it out for taxpayers at higher income levels. Both changes were parts of larger tax packages.
• States could convert their age-based additional personal exemptions to a higher standard deduction — comparable to the one the federal government offers, and which some states already use. This would target these preferences more to lower- and middle-income taxpayers.
• States could replace these tax exemptions for seniors with an expanded state Earned Income Tax Credit (EITC) for seniors. State EITCs offer additional credits on top of the federal EITC, which helps people working in low-wage jobs meet basic needs. Currently workers aged 65 and older are not eligible. Eliminating this age limit would benefit low- and moderate-income seniors who must work after age 65. States could also develop a similar means-tested credit targeted specifically to low-income seniors. Making a state’s tax system less upside-down would also benefit low-income seniors.
• Additional states could rely more on means-tested property tax credits rather than homestead exemptions or credits. For example, circuit breakers provide taxpayers a credit if their income is below a defined level and their property taxes exceed a specified percentage of their income. Currently, 29 states plus the District of Columbia offer property tax circuit-breaker programs, but many of these programs are very limited, and some of the same states also offer homestead exemptions or credits that are not means-tested.^[37]
• States could raise the eligibility age for their age-based credits and exemptions to target them to seniors who are less able to pay. While senior poverty rates generally are lower than they were in the past, the rate among those 75 and older is higher than for those between 65 and 75. By better targeting income and property tax reductions on seniors who are more likely to have low incomes, states can free resources to pay for the growing needs of all seniors while still assisting poor elderly residents.