Social security was created in 1935 by the Social Security Act of 1935. The act created a basic retirement program for working Americans, no matter what their income was. It also established many other social programs, all of which are administered through the Old Age, Survivor’s, Disability, and Health Insurance (OASDHI) program. These other social programs include supplementary social income (SSI), Medicare, public assistance, welfare services, unemployment insurance, and provision for black lung benefits. While all of these programs are essentially dealt with under the same roof, we will only be discussing the old age (retirement), survivor’s, and Medicare portions of the act since they have the most relevance on retirement and financial planning. The purpose of social security is to provide a guaranteed income floor for retired workers, so that they may enjoy a more comfortable retirement lifestyle. It was designed to complement the retirement pension plans that workers were offered by their employers. Therefore, Social Security functions mainly as a government-sponsored retirement plan.
In order really to understand how the system works, and then to generate a prediction as to whether the program will be around to help future generations, we need to discuss how social security is financed, and its solvency.

Social Security’s Financing

The benefits paid to Social Security recipients come from the payroll taxes of those people who are still working today. Many people believe that the social security and Medicare taxes that are taken out of their paycheck (generally listed as FICA taxes, which is roughly 7.65 percent of income) are then set aside for their own use when they retire. This would be like another personal retirement account. However, that’s not the case. Today’s workforce is the one financing today’s retirees. And so, the program is designed to continue throughout perpetuity. Not only do employees pay into the system, so do employers. The employee pays in the 7.65 percent, which the employer matches. That is one reason why self-employed people pay double the amount of social security tax than other “regularly” employed people. The government sees a need to make up for the fact that self-employed people are their own bosses. For those who are self-employed, the FICA tax rate is about 15.3 percent. However, the government then allows them to take one-half of that amount as a tax deduction from their gross income.

When one dollar is paid into social security, it is split into two parts. The first 85 cents goes to a trust fund that pays monthly benefits to retirees and their families, as well as widows, widowers, and children of workers who have died. The remaining 15 cents goes to a trust fund that pays benefits to people with disabilities and their families. Money paid into social security also pays for the program’s administration. These fees come from the two trust funds and amount to less than one cent per dollar paid in.1

The worker pays in his or her 7.65 percent every year until that person reaches a maximum wage base. This base is increased every year due to inflation. The limit for the year 2002 was $84,900. Therefore, the maximum paid in by a worker whose income was at that maximum level would be $6494.85 ($84,900 _ 0.0765). For a self-employed worker, that maximum amount would be $12989.7 ($84,900 _ 0.153). In 1991, a new second tax was introduced to help offset the rising costs of Medicare. Now, after the social security maximum wage base is passed, the new, higher Medicare wage base starts. Employees are subject to a tax rate of 1.45 percent on all earnings above $84,900, with the self-employed paying a corresponding 2.9 percent.

So, for those individuals who earn more than the threshold of $84,900, it would appear that they aren’t paying the fair share of social security tax. And many people do argue that. However, the program is designed so that there is a link between how much a worker earns during his or her working lifetime and how much that person receives in benefits, and the benefits formula is weighted so that lower-income earning individuals receive a higher percentage of their earnings.

Social Security’s Solvency

There is a rampant fear that social security funds will run out eventually. Because of this, many people don’t even count on these benefits as part of the income they will receive when they are retired. Politicians try to calm our fears about social security, but the fact remains that by continuing the trend we are on right now, Social Security benefits will be exhausted by the year 2037.

Social Security Administration.

The main reason for the problem is demographics. Quite honestly, people are living longer, more active lives. And while that is a good thing in general, it’s not such a good thing when it comes to social security. When the program was created in 1935, an average American had a life expectancy of 771⁄2 years. Now, life expectancies are closer to 83 years, and they’re still climbing! What this means is that as more Americans retire, there will be a need for a larger pool of workers to be paying into the system in order to support those collecting benefits. However, that’s not the way our nation’s population is trending.

In 1955, there were approximately seven workers supporting each person receiving Social Security benefits. But in about 30 years, it’s estimated that there will be two people paying money in for every one person drawing money out. That estimate includes all the baby boomers who will begin retiring around the year 2010 (approximately 77 million). All these changes in the population and its makeup will strain the social security system.

Congress has been aware of this problem for a very long time. However, they have only recently begun to take action. This is unfortunate because as long as Congress continues with the status quo, the more likely it will be that social security will become bankrupt. One of the action steps Congress has taken has been to increase the age at which workers can receive full benefits from 65 years to 67 years. For example, if you were to take early retirement now, retiring at age 62, you would receive about 80 percent of your full retirement benefit (what you would have received if you had waited until you were 65). However, once the age increase fully takes effect, if you were to take early retirement, you would only receive about 70 percent of your full retirement benefit. Other ideas to fix the program that have been discussed include raising the social security tax, raising the maximum wage base for the tax, privatizing the system, and raising the retirement age. Of course, all of this is subject to change.

Currently, social security is taking in more money annually than it is paying out. All the excess funds are put into social security’s trust funds, which have about $900 billion right now. Those assets are expected to grow to more than $6 trillion over the next 25 years. However, benefit payments will begin to exceed incoming taxes by the year 2015, and the trust funds will be exhausted by 2037. If no changes are made to the system, Social Security
will only be able to pay out about 72 percent of the benefits owed based on incoming tax money.3

Who Benefits from Social Security?

As a blanket generalization, we can say that if you have held a job, you can receive some type of social security benefits. Of course, there are other types of stipulations that apply. But for the most part, any gainfully employed worker can be covered by social security. In order to qualify for benefits, a worker must earn credits. The number of credits needed depends on when the worker was born. If you were born in 1929 or later, you need 40 credits to receive benefits. If you were born before 1929, you need fewer than 40 credits (39 credits if you were born in 1928, 38 credits for those born in 1927, etc.). Generally, you earn 4 credits per year.This trend will cause the program to begin depleting its trust funds to the point where they are exhausted. By the year 2037, Social Security will only be able to meet approximately 72 percent of its benefit obligations. That money will come directly from the Americans who are still working and paying taxes. If you stopped working before you reach your 40 credits, the amount you have already earned remains on your record. Then, if you go back to work, you will continue to add credits to your record until you qualify. No retirement benefits are paid out until you have reached the required number of credits. However, most people have more than enough credits by the time they retire. All your excess credits do not increase your social security benefit; however the longer you work, the more likely it is that your income will increase, and that will affect how much you receive in benefits.

There are two types of people who are exempt from mandatory participation in the program. First, federal civilian employees who were hired prior to 1984 and are covered by the Civil Service Retirement System are exempt. The second group is comprised of employees of state and local governments who have chosen to not be covered, although an overwhelming majority of these workers are covered under a voluntary participation in the program. Additionally, certain marginal employment positions, such as newspaper carriers under the age of 18 and full-time college students working in fraternity and sorority houses, are also excluded. The largest segment of exempt workers are those who are state and local government employees because these groups aren’t forced to participate since the federal government cannot impose a tax on state and local governments. However, once one of these employees has chosen to be included in the program, they are forced to stay in. They don’t have the option of leaving.

What Kind of Benefit Can I Expect?

The amount of money you receive on a monthly basis from the government is determined by how much money you earned while working. The more money you earned during your working life, the more money you will receive in social security benefits. But, your benefit is also affected by your age—specifically, how old you are when you begin to receive your benefits. The government classifies early retirement as retiring at age 62, while full retirement ranges from ages 65 to 67. (See Table 13.1.) The government has instituted a new retirement age to receive full benefits, but they have done so in a staggering fashion. However, this doesn’t mean that you can’t retire from your job until you are 62 or older. That’s just when you can begin receiving social security retirement benefits. As a worker claiming benefits, you must be no younger than 62 years old. There are other exceptions to this, which are discussed shortly.

If you begin to take your Social Security benefits at age 62, before you hit your full retirement status, your monthly benefits will be less. As mentioned earlier, to take benefits at age 62 when your full retirement age is 65, you will receive approximately 80 percent per month of what you would have received per month if you had waited. If your full retirement age were 67, you would receive about 70 percent of your full benefits by retiring early. This isn’t a punishment for workers who wish to receive their benefits early. Rather, it’s the government’s way of evening things out. To give you full benefits at a younger age would give you more money over your lifetime. The government wants to make sure that no one gets more than their “fair share,” so they reduce the amount of benefits you receive when you begin taking benefits before they think you should.

For example, one of my clients retired from her job in one of our local school districts. Although she was taking money from her investments on a monthly basis as an income, she asked me about beginning her Social Security benefits. I told her that since she was 62 she was eligible, but that she wouldn’t receive the same amount per month that she would if she were to wait until she was 65. Joyce’s monthly benefits at age 65 would be about $1100 per month. But because she begins taking her benefits at age 62, her monthly check will be 20 percent less, or roughly $882 per month.
But not everyone wants to take their benefits early. Some don’t even want to start receiving their checks until after they are 65 years old. By not taking your benefits at full retirement age, you increase your benefits in two ways. First, each additional year that you work adds another year of earnings onto your Social Security record. The higher your lifetime earnings, the higher your benefits will be. Second, your benefits will be increased by a certain percentage if you delay your retirement. These increases will be added in automatically starting from when you reach your full retirement age until you begin to take your benefits, or until you reach age 70. The percentages are based on your birth year, just as your retirement age is. (See Table 13.2.) So if you were born in 1952 and didn’t want to retire until you were 68 years old, you would have an added increase of 16 percent (8 percent per year increase or two thirds of 1 percent per month).

You also don’t have to wait to start claiming your social security benefits until you have actually retired from work. However, there are some limits on how much income you can receive and still have your benefits be 100-percent tax-free. It’s important to consult with your CPA to determine whether your benefits would be taxable if you still plan to work or earn some type of income while receiving your benefits. Your earnings in (or after) the month you reach your full retirement age won’t affect your benefits. But, your benefits will be reduced if your earnings exceed certain limits in the months preceding your full retirement birthday. If you are younger than full retirement age, one dollar in benefits will be deducted for every two dollars in earnings that are above the annual limit. In the year you reach full retirement age, your benefits will be reduced by one dollar for every three dollars in earnings that fall above the annual limit until the month that you reach full retirement age. After that, you can work without any reduction in benefits and no limit on your earnings. The annual limits are increased every year as the average wage rises.

If your family members receive any social security benefits from your record, all the benefits will be affected by your earnings. So, not only will your earnings reduce your monthly benefits, but they will also reduce any other benefits that your family may receive. However, if one of your family members is working, this will only affect his or her benefits, not yours or any others received by your family.

The Social Security Administration has a special rule, though, that they allow you to apply to your earnings and benefits for one year, usually the first year you are retired. Under this rule, you can receive full benefits for any month you are “retired,” no matter what your annual earnings will be. However, your monthly earnings must fall below a set limit. If you are self-employed, your work there is also considered.
If you are currently receiving a pension from your former employer, the amount you receive will not affect your social security benefits, as long as you paid social security taxes at that job. However, if you are receiving a pension from an employer that didn’t participate in social security, such as the federal civil service, state, and local governments, or work in a foreign country, your pension amount will reduce the amount of social security benefits you will receive.

Also, the month you begin taking your benefits may affect how much you receive. In some cases, the month you choose to retire will result in added benefits for you and your family. Taking your benefits early in the year you are going to retire may benefit you more than waiting, even though you aren’t officially retiring until later that year. Under the current law, Social Security recipients receive the most benefits possible with an application that takes effect in January of their retirement year.

Family and Survivor’s Benefits

Social security also offers benefits for those who either worked but didn’t earn enough credits or fall under different categories other than workers. If you are widowed, married, or even divorced, you can claim social security benefits off of the work record of your spouse (or former spouse). If you are receiving benefits, your family members may also receive benefits if they fall into one of the following categories:

- your spouse age 62 or older

- your spouse under age 62, if that person is caring for your child who is under age 16 or disabled

- your former spouse age 62 or older

- children up to age 18

- children age 18-19, if they are full-time high school students

- children over age 18, if they are disabled

Widows and widowers may begin receiving benefits when they are 60 years old, or 50 years old if they are disabled. This also includes divorced widow(er)s. If you are receiving widows’ or widowers’ benefits, you may switch to your own benefits when you reach 62 as long as your retirement benefits are more than what you are currently receiving. Often times, a widow(er) may begin receiving one benefit and then switch to the other (unreduced) benefit when he or she reaches full retirement age.

For spouses, they can receive one-half of their retired spouses’ benefits unless the spouse begins collecting before he or she turns 65. If that’s the case, the benefits are permanently reduced by a certain percentage based on the number of months that are left before the spouse turns 65. For example, if your spouse started collecting benefits at age 62, his or her benefit would be reduced by 12.5 percent, making it 37.5 percent of your benefit, rather than 50 percent. But, if your spouse is taking care of a child who is younger than 16 or is disabled and receiving social security benefits, your spouse will receive full benefits no matter what age.

For those spouses who are eligible for their own benefits, as well as spousal benefits, social security always pays that person’s own benefit first. If the spousal benefit is greater than the regular retirement benefits, that person will receive a combination of benefits. First, they would receive their own benefit. Then, they would receive a benefit as a spouse so that the two benefits combined would equal the (greater) spousal benefit.

There are maximum benefit limits that a family is subject to. If you have children who qualify to receive benefits, each will receiveone-half of your full retirement benefits, but then your family will be subject to the maximum benefit rule. If you find that the total amount of benefits your family is eligible for exceeds the limit, your children’s benefits will be reduced accordingly. Your benefit, however, will be left alone.

Spousal benefit = $750
Spouse’s own retirement benefit = $675
Spouse’s retirement benefit paid first = $675
Spousal makeup benefit _ $75
Total Social Security benefit paid = $750

Divorced spouses may be eligible for Social Security benefits under their former spouse’s work record. The couple must have been married for at least 10 years; the divorced spouse can be no younger than 62 years old and may not be remarried. If the couple has been divorced for more than 2 years, the former spouse may claim benefits even if the other person is still working. However, that person must have the required number (40) of credits needed and be at least 62 years old. Whatever benefits the former spouse receives has no bearing on the amount of benefits the working person will receive.

Taxation of Benefits

Approximately 20 percent of people claiming social security benefits must pay taxes on what they receive. Benefit taxation only affects those people with substantial income in addition to their benefits. To help determine if your benefits would be taxable, the social security Administration sends out a benefit statement to every social security recipient. This mailing shows the amount of benefits you have received. Then, when you are (or your CPA) is preparing your taxes, you will be able to determine if you will need to pay taxes on your benefits.

If you find that you will, in fact, have to pay taxes on your benefits, you may realize that you will also have to pay taxes on you benefits in years to come. You can either have taxes taken out of your monthly checks, or you can opt to pay quarterly estimates. Generally, it’s easier to have a set percentage taken out of your benefit checks.