After recently hearing political candidates argue over Social Security taxes and vowing to make sure that everybody pays their “fair share,” I thought I would dig into the matter a little further.
For some background on Social Security
The Social Security Act was signed by President Roosevelt in August 1935. According to many, the Act was a direct result of the Great Depression. The original act provided for a benefit when a “qualified individual” reached the age of 65. The benefit for someone who retired in January of 1942 and earned an average of $100 per month was about $26.25. This system provided a minimal retirement benefit for those most in need and was weighted in favor of current retirees. Benefits were reduced if workers older than 65 continued employment. The original Act was paid for by a 1% tax on both employees and employers.
When Ida May Fuller received her benefit from Social Security in 1940, her life expectancy was 14 years. Today’s female retirees are expected to collect benefits for 21 years beyond their retirement date. Since 1940, Congress has increased the full retirement age from 65 to 67 which has increased the expected payout by 5 years. The net increase in life expectancy has significantly increased the cost of the program, but nowhere near as much as the 109% benefit increases seen in the 1950’s.
Amendments in 1972 and 1977 established COLAs and automatic increases to the wage-base used to calculate benefits. The purpose of 1972 Amendment was to maintain the relative value of benefits to all recipients but was overly generous. Changes during the early 70’s increased the annual program costs from 3-5% of GDP. The 1977 amendment was an attempt to correct the flawed benefit formula thereby strengthening the trust fund. Changes included adjustments to the tax rate, wage base and the reduction of benefits to make sure that the program would remain solvent.
The 1983 Amendment, again used to sure up the trust fund, began the taxation of Social Security benefits for taxpayers whose Modified AGI exceeded $25,000 single and $32,000 Married filing jointly. It is interesting to note that some 30 years later, taxpayers whose joint income exceeds $44,000 (including all income plus ½ of social security benefits) are now taxed on 85% of their Social Security benefit. These taxes are credited to the trust fund.
So where are we today?
Payments to beneficiaries in 2012 were almost 5% of the gross domestic product and are expected to rise to 7% with the retirement of the baby boomer generation. The maximum monthly benefit is $2,642 or $31,704 annually. (Assuming that the maximum benefit is 85% taxable, the tax affected maximum benefit can be as low as $20,000). Baby boomers full retirement age is between 66-67 years. Taxes of
6.2% are withheld on wages up to $117,000 (max. $7,254), and Medicare tax is withheld at 1.45% on all earned income. According the Social Security Administration (SSA), 63,664,000 people received some type of social security benefit in April 2014. The total benefit paid out in April was $69,348,000,000. The average annual benefit for a retired worker was $15,576. The 2010 SSA analysis on expenditures of retirees reports that the median expenditures for CUs aged 65 or older was $26,486
What is fair and who gets the most bang for the buck?
Benefits are paid out based upon bend points that use indexed monthly earnings for the top 35 highest earnings years on the year that the employee attains age 62. The PIA formula pays out the sum of 90% of the first $816 average indexed monthly earnings (AIME) plus 32% of the AIME between $816-4917 and 15% of AIME over $4,917. It is easy to conclude that the system is designed to pay the most (as a percentage of past earnings) to retirees who have had the lowest earnings wages over their employment years. It matters not how much the retiree has in savings, investments, or inherited assets; the calculation is based only on prior earned income.
In recent years, the SSA released data from 2004 which analyzed the real rate of return, after inflation, for hypothetical workers who had very low, low, medium, high, and maximum covered earnings. The estimated rates of return ranged from -.5% to 9.0% per year. The highest estimated rate of return was for very low wage earners born in 1920. The lowest estimated rate of return was for a maximum wage earner single male, born in 1964. This study also projected that under the current law, the trust fund is projected to be exhausted in 2042.
It seems clear that the program, as it has evolved, has been used as a tool to provide a monthly benefit for retirees. Those who contribute the least receive the highest percentage benefit. Those who contribute the most to the trust fund see the smallest return on their contributions and are likely taxed on the benefits that they do receive. The system does not attempt to establish need, nor does it provide for an equal total benefit for people with the same earnings history. (This can be illustrated by considering that women have life expectancies greater than men and it is, therefore, likely that a woman with exactly the same earnings history will receive a greater lifetime Social Security benefit). It is also true that the system can be and is often manipulated by married retirees through a variety of strategies by taking advantage of “Spousal Benefits.” Common strategies can generate $100,000+ of additional lifetime benefits, provided one knows how to play the game.
It is also clear that politics play a very key role in retirement benefits. Political candidates on both sides of the isle want to protect retirees and the system. Few want to risk their political lives and reduce benefits to those who have paid into the system for years or increase taxes on those most likely to receive the least benefit. What is clear is that with just 20 years before the system goes off a cliff (and only 10 years for Medicare) something must be done. Politicians looking to gather votes or stir up negative campaigns pitting Wall Street against Main Street will only confuse the issue of “fairness” with their vagaries.
Should our current system be defined as providing trust fund benefits for those who have paid into the system or a means of redistributing income/wealth for those most in need? Is it fair that the system does not provide for increasing retirement age even as the population is living longer? Is it fair that many pay income tax on benefits that were previously taxed when earned? Is it fair that couples can take advantage of “claim and suspend” strategies thereby increasing benefits paid? Considering the need for change: Would it be fair to increase the payroll tax rate burden on employers who receive no benefit from the system? Would it be fair to increase the maximum amount of payroll tax on individuals who receive the lowest percentage benefit? Would it be fair to decrease the benefits to those who have contributed the most but “need” it the least? Would it be fair that we ask that our children and grandchildren pay more into the system than we have so that soon-to-be retirees do not have to take a reduction in benefits?
To those of you who are still unsure about who really pays their “Fair Share,” welcome to the club.
James Boulette, CPA