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How to plan for Social Security

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Mandy Nowaczynski, CPA, CFP, is a Tax Planner with Annex Wealth Management.

The future of Social Security has been discussed and debated at length, fostering all sorts of divergent opinions on the program’s viability. One negative outcome of all the dissonance is uncertainty.

Uncertain if their benefit will be available later, and typically – with very little saved for retirement – many are choosing to claim Social Security at age 62. Unfortunately, collecting early often causes benefits to be permanently reduced.

How is Social Security funded?

Social Security is funded through a payroll tax, known as FICA taxes, which totals 7.65 percent of employee’s wages, with employers paying a matching portion. FICA taxes consist of Social Security (6.2 percent) and Medicare (1.45 percent), and the Social Security funds are paid into the Social Security Trust Fund.

The contributions into the fund are invested in “special issues,” which are investments only available to the Trust Fund – non-marketable U.S. Treasury securities, backed by the U.S. government.

A brief history

It’s important to clarify the historical sequence of events to understand risks to current Social Security benefits. Social Security was signed into law on August 14, 1935. The first monthly benefit check was issued on January 31, 1940 for $22.54.

The program has faced funding issues throughout its history, which resulted in changes to its benefit and taxation structure. The most notable changes came in 1977 and 1983, when steps were taken to help keep Social Security funded.

In 1977, an amendment was issued to increase wages subject to the Social Security tax while simultaneously increasing the rate assessed on income. 1983 saw even more changes to the program’s payment structure. Two of the most wide-reaching changes were gradually increasing the full retirement age from 65 to 67 for those born after 1960 and taxing the receipt of Social Security benefits.

Starting in 2010, the program faced another crisis: an increase in retirees meant the amount being collected through payroll was not enough to cover benefits being paid out. So far, Social Security has avoided a shortfall because its Trust Fund collects interest on the securities owned there.

Depletion is near

But the respite is short lived. In 2018, for the first time since 1982, Social Security’s total project costs are anticipated to exceed their income, resulting in an annual loss in the Trust Fund. This will result in the start of the depletion of the Trust Fund’s reserves. The 2018 Annual Trustees Report states that, without further action, the Trust Fund will be depleted by 2034.

Without changes to the program, 2034 will see payroll taxes collected and then sent right back out to pay current benefits. Projections show that in 2034, total revenue (payroll taxes) will be able to pay out 77 percent of the scheduled benefits until 2092, when the amount paid out will drop.

No clear-cut solution

While the program itself will likely be around long into the future, changes will need to be resolved to address the shortfall of funds starting in 2034. These solutions may not be interdependent of each other, but any combination of these could be enacted to help the shortfall.

Here are some of the options Congress has available to improve the prospects of the Trust Fund:

  • Raise the earnings cap. Currently employees pay 6.2 percent of their income up to $128,400 to the Trust Fund. By either increasing the cap on which the rate is accessed, or removing the cap altogether, the Trust fund would see more inflows to pay scheduled benefits.
    Projected effectiveness: Gradually increasing the payroll tax could eliminate the entire shortfall, but the rate would need to be increased to 9 percent by 2058. By removing the earnings gap entirely, up to 71 percent of the Social Security deficit could be eliminated.
  • Raise the full retirement age. Right now full retirement age is 67, and increasing the age would reflect data that show Americans are living longer than ever before, can work longer, and that work itself is easier than it has been in past eras.
    Projected effectiveness: Gradually delaying the age to 68 could eliminate up to 16 percent of the shortfall.
  • Adjust the benefits formula. Currently Social Security benefits are based on a worker’s highest earnings over a 35-year period, adjusted for wage growth. The system uses a progressive formula that effectively results in more annual income for those that have earned less than higher earners. One possibility would be adjusting the formula so that those who have earned less would receive lower benefits.
    Projected effectiveness: Because reduced benefits would greatly impact the ability to fund living expenses of lower-income families during retirement, many do not see an adjustment like this happening.
  • Adjust the cost-of-living calculation. Social Security benefits are currently increased along with the consumer price index (CPI). The proposed adjustment would use another index to calculate the annual increase, referred to as chained CPI, resulting in lower annual increases to Social Security benefits. Chained CPI has become an increasingly popular method to calculate inflation, since it was used to make inflation adjustments to tax brackets in the Tax Cuts and Jobs Act passed at the end of 2017.
    Projected effectiveness: This strategy could eliminate up to 21 percent of the deficit.

Overall, Social Security will still be around for many years, but it’s prudent to expect changes to the current structure.

When planning for retirement, talk with an advisor you can trust about Social Security as one of your income sources during retirement. It’s still a relevant aspect for many during retirement years, and it’s important to consider all aspects of financial planning when deciding what age to start receiving benefits.

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