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Social Security Isn't 'Going Away'

Here's what you need to know about Social Security and your retirement plan, Millennials and Gen Xers.

The Treasury department recently released a scintillatingly titled report. It was called "The 2021 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds." (Talk about provocative!)

All joking aside, every year when this report comes out there are headlines saying things like "Social Security is going broke! Millennials should worry" and "Gen Xers--you should worry, too!"

And we are concerned: A Gallup poll conducted in 2015 indicated that nearly two thirds of all workers polled between the ages of 18 and 49 didn't believe the Social Security system would be able to pay them any benefit when they retire. Not even a dime.

Is that true? Should we worry that Social Security won't be there when we need it?

How Social Security Pays Benefits

The headline this year was that the Treasury predicts the trust funds will be exhausted even sooner--by 2033, not 2034.

But that doesn't mean Social Security will cease to exist in a decade or so, because the interest in these trusts is not the major source of funding for these benefit payouts. Most of the benefits that Social Security pays out (nearly 90% in 2020) are funded by payroll taxes, which aren't going away.

The Social Security Administration describes Social Security as a "pay-as-you-go program," which means payroll taxes collected from today's workers are used to pay benefits to today's recipients. When we retire, the taxpayers who are still working will fund our Social Security benefits.

It works like this: If you work for a company, the government collects 6.2% of your paycheck (and your employer pays another 6.2% on your behalf) up to the Social Security wage cap, which is $142,800 in 2021. Another 1.45% of your salary is collected for Medicare (plus another 1.45% from your employer, for a total of 2.9%; there is no wage cap for the Medicare tax). Social Security and Medicare withholding is also known as FICA. (For more, see "How Much in Taxes Is Taken Out of Your Paycheck?")

In 2021, $0.85 of every Social Security tax dollar you pay goes into a trust that pays monthly benefits to current retirees and their families, and to the surviving spouses and children of workers who have died. The remainder goes into a trust that pays benefits to people with disabilities and their families, and a small portion is used to cover the costs of managing the Social Security programs.

So, even though you "pay into" Social Security, it doesn't work the same way as making a contribution to a retirement account (such as a 401(k)) and withdrawing that money later. When you work and pay Social Security taxes, you earn credits that qualify you to earn benefits when you retire. The amount of your earnings and work history determine your eligibility for retirement or disability benefits, or your family's eligibility for survivors benefits when you die.

In 2021, you receive one credit for each $1,470 of earnings, up to the maximum of four credits per year.

What Are the Social Security Trust Funds?

The tax revenues collected don't exactly equal the benefits being paid out. That balance depends on lots of factors like demographic shifts and employment rates, but for over 30 years, more taxes were collected than benefits paid out. When the money coming in to Social Security exceeds the program's payment obligations, the extra money is credited to the trust funds.

The Old-Age and Survivors Insurance and the Disability Insurance trust funds are separate entities but are often referred to collectively as OASDI. The trusts serve as a way to track the accounting--payroll taxes collected, benefits paid out, and administrative expenses paid. If the taxes collected exceed the amount paid out, the excess is credited to the trust funds and invested in interest-bearing U.S. Treasury special issue securities.

In years when the benefits paid out exceed the tax revenue collected, the Social Security Administration will make up the shortfall by dipping into the trust funds.

Currently, the OASDI trust funds have over $2.8 trillion, according to the Social Security Administration. There are only sufficient excess funds for the next few decades, though. If no steps are taken to bridge the gap between the taxes collected and the rising costs of benefits, Social Security's board of trustees projects that the combined trust funds will be exhausted in 2033. After that point, continuing tax revenue is expected to be sufficient to cover around three fourths of the expected benefits.

What Happens When the Trusts Go Bankrupt?

The "Social Security's trust funds are going bankrupt" rallying cry was never meant to be interpreted to mean that the program would eventually cease to exist. Rather, it was a call to action by Social Security's board of trustees that there would be a significant drop in the level of benefits that would be payable if no legislative action were taken to rectify the financing shortfall between now and 2033.

Morningstar's head of policy research Aron Szapiro says it's unlikely that no action will be taken, however. He believes that Congress has many levers available to it that would allow it to address the shortfall: A cost-of-living adjustment for Social Security could be a likely change, paired with an increase in the normal retirement age and increased tax caps.

"Social Security has always been a pay-as-you go system with the trappings of a prefunded system," Szapiro says. "Pay-as-you-go pensions are fundamentally as strong as the economy, tax base, and political influence of the beneficiaries. From that frame, I have little to no doubt that Congress will continue to prioritize paying Social Security benefits."

This sort of action is not without precedent. In 1983, Congress took action to address a coming intergenerational inequity. It raised payroll taxes and cut benefits in order to build up a reserve to support benefit payments for the large wave of baby boomers who would start retiring around 2010.

Factor Social Security Into Your Plan

If you hadn't been including Social Security in your long-term financial plan, you should factor it in, keeping in mind the possibility of a reduced benefit.

Also don't confuse three fourths of the expected benefit payment with 75% of your total monthly income needs. Social Security was never intended to be the only source of income for people when they retire.

Social Security replaces a percentage of your preretirement income based on your lifetime earnings. This percentage is higher or lower depending on how much you earn and how old you are when you file for benefits. If you wait until full retirement age, Social Security can replace up to 75% of income for very low earners, about 40% for medium earners, and about 27% for high earners. Every year you delay claiming benefits (until age 70), these percentages increase.

A good rule of thumb: Aim to replace 80% of your preretirement income from a combination of investments, savings, and Social Security.

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