Two Social Security tax fixes: $400,000 donut hole and a health-benefit tax

Social Security's financing is back on Washington's agenda, and the Tax Foundation has set out two ways to patch the program that land on opposite sides of the work-incentive debate. One would impose the 12.4 percent payroll tax on earnings above $400,000 while leaving the current $184,500 cap intact, creating a 'donut hole' of untaxed income between the two. The other would end the payroll tax exemption for employer-sponsored health insurance, treating premium value as taxable compensation. The foundation argues the choice is about more than revenue; it is about how the tax system treats the next dollar of work.

The comparison appears in a blog post accompanying Options for Reforming America's Tax Code 3.0, the group's guide to tax-reform trade-offs. The post opens with a countdown: debt held by the public has reached 101 percent of GDP, and Social Security is projected to become insolvent by 2032. Lawmakers, it says, will soon be forced to put the country's finances on a sustainable path through some combination of benefit cuts, tax increases, and efficiency reforms.

The donut-hole plan, labeled Option 45, is a compromise version of the perennial proposal to lift the payroll tax cap. Rather than abolishing the cap, it taxes earnings up to $184,500, leaves earnings between that and $400,000 untaxed, and then applies the 12.4 percent tax again above $400,000. The upper threshold is not indexed to inflation, so the tax-free band would shrink in real terms over time, pulling more income into the taxable zone as wages rise.

The Tax Foundation is explicit about the drawback. The donut hole raises substantial revenue, but it increases top marginal rates on labor income and penalizes additional work. The arithmetic is straightforward: a high earner above $400,000 would owe 12.4 cents on every additional dollar earned. That is a heavy tax on the activity the system is trying to encourage.

The alternative takes aim at a different gap. Employer-sponsored health insurance currently escapes the payroll tax altogether. Eliminating that exclusion would bring a large pool of compensation into the payroll base, the foundation says, raising significant revenue without substantially changing work incentives. Because the added premium income would push some taxpayers past the taxable maximum, their next dollar of wages would face no payroll tax. The move would also reduce a long-standing distortion that favors health benefits over cash compensation.

The two designs would touch different clients. The donut hole is a high-income problem, hitting anyone whose earnings cross $400,000 with a new 12.4 percent marginal rate. The health-insurance option would show up on the W-2 of every employee with company coverage, broadening the payroll base for a much larger population. For advisors, the proposals are useful stress tests. The donut hole creates a cliff in an income projection: once earnings pass $400,000, each additional dollar of wages or self-employment income attracts an extra 12.4 percent tax. The health-insurance option would add premium value to the payroll base, which for some workers would push them past the taxable maximum and actually lower the marginal rate on the next dollar of cash wages.

The Tax Foundation leaves little doubt about which it prefers. The post's own title calls the options guide 'a better way to fund Social Security,' and its analysis of the two designs is one-sided. The donut hole's work penalty is the central argument against it; the health-insurance approach's lack of a work penalty is the central argument for it. But the guide's larger point is that the payroll tax is no longer just about the cap. The debate now includes what counts as wages.

None of this is law, and the report is not a prediction. It is a framework. The Social Security trust fund's projected insolvency puts every payroll tax design on the table, and the range of options runs from taxing the very rich again to taxing employee benefits for everyone. Advisors who map either scenario onto a client's long-term income plan will be ahead of the conversation when a proposal actually lands.