A cost of living adjustment (COLA) is a change in the amount of your Social Security benefit payment that is made to reflect an annual increase in consumer prices.
With a COLA, your monthly Social Security payment is indexed for a certain measure of inflation. When that tracker of inflation rises, your monthly retirement income will rise with it.
This feature sets the Social Security program apart from other defined payout plans, like pension plans, that pay a fixed amount each month with no regard for how high the inflation rate might rise. Inflation indexing protects against the impact of shifts in the value of the dollar and helps retired people afford to stay retired.
Knowing about how the COLA came to be, how it is calculated, and how it might serve you, can help you stretch your nest egg further after you retire.
How Did COLA Come to Be?
Social Security benefits have been indexed to track inflation since 1972. This came about as a result of a number of laws that Congress enacted as part of the 1972 Social Security Amendments. At first, a new law was needed each time Congress wanted to adjust payments, which posed quite a burden to keeping benefits on pace with the high inflation at the time.
Starting in 1975, COLAs became automatic. This shift occurred when Congress linked COLA to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), to increase Social Security payments with rises in price without all the hassle of enacting new laws. When the CPI-W increased by at least 3%, it would prompt need for a COLA, but this trigger method didn't last long. In the mid-1980s, rates of inflation were lower than normal, which led to a few years that saw no COLA under the 3% trigger, so in 1986, Congress discontinued it.
Under the current scheme, when inflation is going up, Social Security payments will still increase to reflect rising costs. Social Security COLAs are now made based on rising CPI-Ws. To be precise, COLAs occur based on the rise in the CPI-W from the third quarter of one year to the third quarter of the next year, as measured by the U.S. Department of Labor.
Although the average annual inflation rate from 1913 to 2020 is around 3%, the Federal Reserve targets a rate of 2% as it carries out monetary policy.
What is the Purpose of a COLA?
COLA is designed to protect against inflation, but the intent may not be what you think. The goal of COLA is not to increase the standard of living of people who receive Social Security payments, but rather to maintain the purchasing power of income benefits over time. Inflation indexing during a one- or two-year span doesn't have a major impact on the amount you'll see on your monthly payment checks. But over the course of 20, 30, or 40 years, or however long a healthy person might expect to live in retirement, it could have quite an impact. The value of the dollar might change a great deal from one decade to the next, and though monthly benefit checks may look to be the same amount over time, their worth will fall. In other words, COLA attempts to maintain the status quo. This feature has the most impact during times when inflation is high.
For example, if you retire, and the current inflation rate is 2%, your income would have to increase by around 50% from age 65 to 85 just to keep a steady standard of living. If inflation were 4%, that income would have to more than double during those 20 years to maintain your standard of living. The purchasing power of your dollar, or its value on the market, goes down when inflation goes up. If your benefit check were to stay the same amount from one year to the next, it would pay for less and less over time. COLA aims to prevent the value of your money from being eroded over time. It reflects Congress's belief that for any given year, retired people should be able to afford the same amounts of goods and services with their income as they did in prior years.
How Is COLA Calculated Each Year?
The amount of the increase you'll see on your monthly check depends on the CPI-W, which measures the change in the price of a basket of consumer goods. CPI-W uses a sample person who works in an urban job and is paid in wages as a model to come up with base figures. It then measures how changes in prices will affect a segment of the model worker.
A very specific formula drives the findings of the COLA. A COLA occurs if the average CPI-W from the third quarter of the prior year to the same quarter of the current year increases by at least 0.1%. If the CPI-W decreases or increases by less than 0.05% (a figure that is rounded down to zero), there is no COLA and, hence, no change in Social Security benefits.
If the CPI-W reveals a change within the given spectrum, Congress may decide to enact a new COLA. They often announce new COLAs during the month of October. Any adjustment will then apply to benefits paid in January of the next year.
How Have COLAs Changed Over Time?
Throughout history, the Social Security COLA increase has varied. So too has the Social Security maximum taxable amount, which is the highest dollar amount that is subject to the Social Security tax. Over the last few decades, the annual COLA has been as high as 14.3% (as it was in 1980, a time of high inflation) and as low as 0%, as it was in 2010, 2011, and 2016.
In 2021, the COLA increase was 1.3%, and the highest amount of taxable earnings in 2021 were $142,800. In 2022, the COLA will see a significant increase to 5.9%, with the threshold for taxable earnings set at $147,000.
Taxable earnings include all forms of income and wages, as well as net profits from self-employment.
Does a COLA Impact IRS Income Limits?
Caps on Social Security retirement earnings also adjust with COLAs. Some people opt to receive the Social Security benefit before their full age of retirement, as deemed by the IRS. Half of their earnings above a certain threshold that is set each year are taxed. In 2021, the 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 assessing your income tax liability each year. It shifts as you retire, but only if you are of a certain age. For Social Security, this age varies based on when you were born: it is age 66 for those born from 1943 to 1954, and 66 and 2 months for those born in 1955.
For people who have reached the year in which they will turn the full age of retirement, their earnings are taxed $1 of each $3 they earn above a second threshold, if it is reached before their birthday. That amount was $50,520 in 2021, and it is $51,960 in 2022. Starting in the month of the birthday at which they reach full retirement age, the earnings limits no longer apply.