The Social Security Cost of Living Adjustment (COLA) in 2025 may not increase your monthly benefits as much as you think

Retirees who collect Social Security benefits get a raise almost every year to help their checks keep up with the rising cost of living. The government will need a few more weeks to finalize the numbers for next year's cost-of-living adjustment (COLA). If all goes according to plan, retirees should see a 2.5% increase in their benefits starting in January.

That number might be disappointing considering there's an 8.7% COLA in 2023 and a 3.2% adjustment this year. What's more, many retirees may not even get a 2.5% increase in their monthly checks. Here's why.

Medicare costs are rising faster than inflation

The Social Security Administration (SSA) automatically deducts Medicare Part B premiums from beneficiaries' checks if they are enrolled in the government-sponsored health insurance program. You become eligible for Medicare at age 65, and the SSA will automatically enroll you in Part A and Part B if you have already received retirement or disability benefits.

The cost of Medicare premiums increases each year to cover the cost of healthcare for America's seniors. The Medicare Board of Trustees estimated a rise in the monthly Part B premium for most households from $174.70 to $185.00. That represents a cost increase of 5.9% and is much more than the estimated 2.5% COLA.

Put another way, the average retiree currently receives $1,872 in monthly retirement benefits. A 2.5 percent increase equates to $46.80 per month, but about $10.30 of that will go toward paying higher Medicare premiums. As a result, the average retiree will only receive about a 2.2 percent increase in their current checks.

Don't forget taxes

The Social Security Administration withholds taxes from your monthly check only if you ask for them, and then only at preset percentages ranging from 7% to 22%. But whether the SSA withholds taxes from your monthly check or not, next year's COLA will likely mean an additional tax burden for many retirees.

The federal government's taxation of Social Security is based on a value called total income, which is equal to half of your Social Security benefits plus your adjusted gross income and any untaxed interest income. If your total income exceeds certain thresholds, a portion of your Social Security benefits is counted as taxable income subject to federal income tax.

Here are the thresholds:

Data source: Social Security Administration.

As you can see, these thresholds are extremely low. What's more, the SSA doesn't adjust them for inflation. As a result, each year more and more retirees have to pay taxes on an increasing portion of their benefits.

When considering the impact of the COLA on your net income, consider the marginal tax rate on your COLA. If 85% of your COLA is taxed at 12% or 22%, the actual value of the COLA for your budget is reduced by 10% or 19%, respectively. In addition, you may be subject to state income tax on your Social Security benefits if you live in one of nine states.

Secure your Social Security COLA

Understanding how the above factors affect your monthly Social Security benefit is half the battle in ensuring you get as much out of the COLA as possible. While there's not much you can do to stave off the rising costs of health insurance and healthcare, the Social Security program does have some built-in protections.

The hold harmless provision ensures that your Medicare premium does not increase more than your Social Security benefit. However, doing so could eat up the entire benefit increase.

When it comes to taxes, understanding the factors that go into your overall income is the first step. To effectively combat Social Security taxation, you need to plan ahead and pay taxes up front to avoid higher taxes later. The most commonly used tool is the Roth conversion, which allows you to pay taxes now to make tax-free withdrawals in the future. You may also be able to strategically use capital losses to offset capital gains and keep your adjusted gross income low while you live off your investments.

For many seniors, however, the reality is that next year's COLA will not lead to the expected increase in purchasing power that the headlines suggest.