How Does the Windfall Retirement Tax Work?

The windfall elimination provision reduces or cancels a retiree's Social Security benefits if the retiree collects certain types of pensions, such as a pension from a state or local government or a nonprofit. Employees of these organizations may be exempt from Social Security withholding because their employer offers an alternative retirement plan.


Contribution Years

The amount of the benefit reduction varies, depending on the number of years that a taxpayer pays into Social Security. If the taxpayer pays into Social Security for at least 10 years, he receives some benefits. A taxpayer who pays into Social Security for 20 to 29 years receives more benefits, and if the taxpayer pays into Social Security for 30 or more years, he receives full benefits even if he receives another pension.


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Income Sections

Social Security separates a worker's average income into three sections to calculate her retirement benefits. In 2010, the first section is monthly income up to $761, the second section is monthly income between $761 and $5,347, and the third section is income above $5,347. The Social Security Administration multiplies each section of income by a different factor to calculate the monthly benefit. This system allows workers who earn lower wages to collect more benefits in retirement, because the factor for the first section is 90 percent, the second factor is 32 percent, and the third factor is 15 percent.


Factor Reduction

The windfall elimination provision only applies to the first section of income, and it reduces the size of the factor that applies to this income. If the worker paid into Social Security for 10 to 20 years, the factor is 40 percent. The factor increases by 5 percent for each year after 20, from 40 percent up to the maximum of 90 percent, so a worker who contributed to Social Security for 25 years and receives another pension would have a percentage of 75 percent applied.


Other Adjustments

The windfall elimination provision applies before other adjustments to Social Security benefits, including the adjustment for age of retirement. A worker who collects benefits at the minimum age of 62 receives a smaller penalty, and a worker who retires at the maximum age of 70 receives fewer additional benefits. The cost of living adjustment, which increases the amount of benefits each year because of inflation, is also smaller because of the windfall elimination provision.