CHAPTER
3

How Social Security Works

In This Chapter

The answer to how Social Security works is simple: you and I, along with our employers, pay taxes under the Federal Insurance Contributions Act (FICA) that go into a trust fund that pays Social Security benefits.

Sounds pretty simple, right? In reality, to finance this vast program, the Social Security Administration (SSA) relies on a number of complex formulas and regulations that would give a nuclear physicist a headache.

Is It Really Your Money?

Many people think the money they put into the Social Security trust funds is really their money and that the government is holding on to it until they retire. If only it were that easy! Yes, you may have contributed to the trust funds through taxes, but there is no account in your name containing your contributions. There is, however, a record of how much money you earned and how much you contributed to FICA through payroll taxes.

The way this works is that the money you put in today is paying for those people who are getting benefits today. If you are not collecting Social Security benefits yet, someone else will be paying for your benefits down the road. So the short answer to the question “Is it your money?” is no. You are paying for someone else’s benefits just as other workers will pay for yours.

Now, there is some ambiguity about those of us who collect Social Security and still pay FICA taxes. In that case, some of the money could be yours, but the important takeaway here is that most of us who are paying Social Security payroll taxes today are not contributing to our own benefits in the future, but to someone else’s.

DEFINITION

FICA, short for the Federal Insurance Contributions Act, is the federal law that requires payroll deductions to pay for Social Security and Medicare. Both employees and employers share the contributions; if you’re self-employed, you are responsible for the entire contribution.

Another reason not to think of this as your money is your contributions actually go into two trust funds: the Old-Age and Survivors Insurance (OASI) Trust Fund and the Disability Insurance (DI) Trust Fund. Your money could just as easily be paying for someone else’s disability benefits instead of for retirement because the funds are linked and are often referred to as the Old-Age, Survivors, and Disability Insurance, or the OASDI Trust Fund.

Here’s another factoid that might make your head spin: the Social Security trust funds do not contain any cash or saleable assets. Then what do they contain, you might ask? This is where things get a little murky. According to the SSA, the trust funds basically represent the amount of Social Security FICA taxes that were collected beyond the amount needed to pay today’s benefits. These excess funds were then converted into special Treasury bonds.

What makes these bonds special is that although they pay the same interest as other bonds the government sells to the public, these bonds can’t be sold. They can only be repaid through higher taxes on future workers. Those annual surpluses that most of us thought were going to be there when the rest of us Baby Boomers begin collecting benefits are gone. They’ve actually been used to fund other government programs.

Still with us? Now comes the really strange part. None of this matters because the federal budget’s definition of a “trust” bears little or no resemblance to the term as used in the private sector. In the private sector, trust funds invest in things like stocks and bonds or other asset-backed securities with the goal of growing the fund’s revenues by maximizing earnings within a previously agreed-upon level of risk.

With the OASDI, the federal government owns the assets and earnings and it can raise or lower future trust fund collections and payments or change the purpose for which the collections are used. What this means is that the balances in the OASI and DI to be used to finance future benefit payments exist only on paper or in some digital file as a bookkeeping notation. There are no real assets here that can be withdrawn to pay for benefits.

What are they, then? Basically they’re claims on the Treasury that when redeemed will have to be financed by raising taxes, by borrowing from the public, or by reducing the benefits. That’s right. The Social Security trust funds contain no funds at all! They’re simply a way to show how much the government has borrowed from Social Security but do not provide any methods of financing future benefits.

Who Pays into Social Security?

You and I, and our employer (if we have one), pay taxes and this money goes to the Treasury. It’s up to the Treasury to estimate how much of these taxes are for Social Security through FICA and then credit the trust funds with that amount. This means the Treasury doesn’t actually deposit the money into the two trust funds. It makes an accounting note that looks like the money is in the fund, but it really isn’t.

WORTH NOTING

Both Social Security trust funds are invested entirely in U.S. Treasury bonds that have special features in that they never fluctuate in value and they can always be redeemed at par.

At the end of the year, the estimates are adjusted after the actual income tax returns show how much real payroll tax was actually paid that year. We should add that the Treasury also credits the trust funds with any interest that would have been paid on its balances, along with the amount of income taxes higher-income workers paid on their Social Security benefits.

So that’s what happens to the money collected. But what about the money going out? Where does that come from?

Well, the SSA tells the Treasury to pay the monthly benefits, and that amount is subtracted from the total shown on the books as being in the funds—even though the money is not really there.

Anything left over—the surplus—is, as we said earlier, converted into special-issue Treasury bonds that are basically IOUs the government gets to use when they’re needed.

However, those surpluses ended in 2010, when Social Security began to pay out more in benefits than it was taking in. According to the SSA, the OASDI spent almost $44 billion more in 2013 than it brought in through the FICA payroll tax. And it expects the gap to continue growing until annual deficits grow to $153.6 billion by 2020. If that seems alarming, consider this: the SSA thinks the trust fund will run out of money in 2033.

When that happens, the Office of Management and Budget (OMB) says there are four ways Congress can repay the bonds and save Social Security:

  1. Raise income taxes.
  2. Authorize the Treasury to borrow the needed funds from the public.
  3. Reduce spending on other federal programs.
  4. If all else fails, cut Social Security benefits.

Who Doesn’t Pay into Social Security?

Most of us pay Social Security taxes; however, there are a few exemptions. Some public and government employees are exempt in states that voted not to opt into a provision of the Social Security Act called the Section 218 Agreement covering public workers. This includes teachers, firefighters, police officers, prison employees, and state and local government employees. For example, teachers in Georgia don’t pay Social Security taxes. But they can’t apply for Social Security benefits, either.

Others exempt from paying Social Security taxes include members of some religious groups; they, too, must waive their right to receive any benefits.

Employees of foreign governments living in the United States don’t have to pay Social Security taxes as long as the work they’re performing is for the foreign government.

Children under the age of 18 who work for their parents in family-owned businesses don’t have to pay Social Security taxes on their earnings as long as the business is solely owned or a partnership in which the child’s parents are the partners. Finally, children under 21 who do domestic work, housekeeping, babysitting, and yard work don’t have to pay taxes on their earnings.

FICA

For the rest of us, and the overwhelming majority of American workers, Social Security and Medicare taxes are collected under the Federal Insurance Contributions Act (FICA). These taxes represent 12.4 percent of earned income up to an annual limit. In 2014, that limit was $117,000.

In 2015, the limit increased to $118,500 Currently, 6.2 percent of your FICA tax is withheld from your income, while your employer covers the remaining 6.2 percent.

What If You’re Self-Employed?

If you happen to be among the lucky ones who have your own business or work for yourself, estimated at 10 million Americans in 2013, or 6.6 percent of all reported jobs, according to a report from CareerBuilder and Economic Modeling Specialists Intl (EMSI), you still have to pay Social Security taxes. The only difference is that, because you are your own boss, you have to pay the entire amount, 12.4 percent, instead of the 6.2 percent paid by those who are not self-employed.

The good news, though, is that because of this you are eligible for two income tax deductions those who are not self-employed cannot get. First, your net earnings from self-employment are reduced by half of your Social Security tax. Second, you can deduct half of your Social Security tax on IRS form 1040. There are some qualifiers, however. You have to deduct it from your gross income and it can’t be an itemized deduction, which means you can’t list it on your Schedule C.

It’s interesting to note that, according to the CareerBuilder and EMSI self-employment study, the number of self-employed has actually declined since its peak from 2001 to 2006, with the 5 percent decline since 2009 blamed on the recession. Thirty percent of those who are self-employed are 55 years of age and older.

WORTH NOTING

If you want to learn more about self-employment and Social Security benefits, access the publication, “If You Are Self-Employed,” posted free online by SSA at ssa.gov/pubs/EN-05-10022.pdf. This is the 2014 version. They usually issue updated versions on an annual or regular basis.

Earning Work Credits Toward Future Benefits

The SSA determines your eligibility as well as the amount of your monthly benefits based on your work history. In order to qualify for retirement benefits, you will need at least 40 work credits, or four credits a year for 10 years. In 2014, you earned one credit for each $1,200 earned. In 2015, that increased to $1,220. The most you can earn in one year is four credits. (This topic will be discussed in greater detail in the next chapter.)

QUOTATION

“For many retirees, Social Security benefits represent their largest financial asset. Unfortunately, most Americans decide when to begin Social Security benefits without any advice…. Representatives at the Social Security Administration are not allowed to give advice (even if asked) and can only provide information and details on the rules. And few advisors have the training and knowledge to help a retiree select a Social Security claiming strategy.”

—William Reichenstein and William Meyer, Social Security Strategies, page ix.

The Least You Need to Know