For better or worse, Social Security is leaned on by more Americans than any other social program. With no disrespect to Medicare, Social Security provides a payout to more than 62 million beneficiaries a month, around 70% of whom are aged 62 and over and receiving a retired worker benefit. Of these aged beneficiaries, better than three out of five rely on the program to provide at least half of their monthly income. It’s simply that vital to the well-being of our nation’s elderly.
However, it’s also true that Social Security is set to face some serious issues in the years and decades that lie ahead.
Social Security is headed toward a cash crunch
According to the most recent annual report from the Social Security Board of Trustees, the program will undergo a major change this year. More specifically, expenditures, which include benefits paid, disbursements to the Railroad Retirement exchange, and general and administrative costs to run the Social Security Administration, will exceed collected revenue by an estimated $1.7 billion in 2018. After a slight retracement to a net cash outflow of $0.2 billion in 2019, the program’s outflow is projected to rapidly accelerate in 2020 and beyond. By 2027, the short-range (10-year) forecast is calling for a $169 billion single-year net cash outflow.
As you might rightly imagine, Social Security can’t continue to burn through its $2.9 trillion saved up in asset reserves without consequences. By the time 2034 rolls around, changing demographics and congressional inaction will have completely exhausted the program’s excess cash.
Now, for the good news: Social Security isn’t going anywhere. Even without any excess cash, the program brings in a vast majority of its annual revenue from the 12.4% payroll tax on earned income up to $128,400, as of 2018, as well as the taxation of benefits, to a far lesser degree.
The bad news would be that this net cash outflow suggests the current payout schedule isn’t sustainable. The Trustees report has intimated that an across-the-board benefits cut of up to 21% may be needed in order to sustain payouts through 2092, without the need for any further cuts.
What is Social Security’s payroll tax?
Broken down even more, Social Security needs to overcome a $13.2 trillion cash shortfall between 2034 and 2092, and it can do so in three ways: raise additional revenue, cut expenditures, or institute some combination of revenue-raising and expense-cutting.
If we were to let the American public choose, they’d prefer to see the program raise additional revenue. And the easiest way to do that would be to adjust the maximum taxable earnings cap associated with the payroll tax.
As noted, Social Security’s payroll tax is a 12.4% tax on earned income (wage income, interest, and dividends, but not investment gains) between $0.01 and $128,400. This means that every dollar earned above $128,400 will be exempt from Social Security’s payroll tax. Since more than 90% of working Americans will make less than $128,400 in earned income, it means more than nine out of 10 workers are paying into Social Security with every dollar they earn.
It’s also important to understand that most workers aren’t paying the full 12.4% payroll tax, as mandated by law. If you’re self-employed or a contractor, you certainly are. However, if you’re employed by a company or someone else (i.e., not receiving a 1099 tax form), your employer is responsible for covering half of your payroll tax liability (6.2%). Thus, most workers are only paying into Social Security on 6.2% of their earned income.
Why isn’t this payroll tax applied to all earned income?
Now, here’s where things get interesting.
The rich do, technically, pay more into the Social Security program in most years. That’s because the maximum taxable earnings cap (the $128,400 figure in 2018) is tied to the National Average Wage Index (NAWI). If the NAWI increases by 3%, we should see the taxable cap jump by an equal 3%.
The one exception to this rule would be in instances where no cost-of-living adjustment (COLA) is passed along to beneficiaries. In such a case, as in 2010, 2011, and 2016, the taxable earnings cap remains the same as the previous year(s). Of course, in subsequent years, when COLA does get passed along to beneficiaries, the taxable earnings cap can really jump as it plays catch-up, just as it did in between 2016 and 2017, when it rose from $118,500 to $127,200.
But you might be wondering, “Why does this cap exist in the first place?” After all, estimates suggest that completely removing this taxable cap and exposing all earned income to the payroll tax would generate enough additional revenue to completely offset the program’s expected shortfall of $13.2 trillion. The answer to that question can be found in the construct of the Social Security program itself.
In mid-October of every year, the Social Security Administration updates a number of figures for the program to account for inflation, including those for the retirement earnings test, the maximum taxable earnings cap, and the amount a beneficiary can receive each month at full retirement age. In 2018, this latter figure is $2,788 a month, regardless of whether you averaged $150,000 a year in earnings during your four-decade career or $10 million a year. It’s the fact that retired worker benefits are capped on a monthly basis that also influences how much earned income becomes taxable.
Now, this isn’t to say that lifting or removing this taxable cap isn’t on the table. Democrats on Capitol Hill have regularly proposed doing so, which would require the well-to-do to pay more into the program. However, in doing so, the wealthy wouldn’t receive an extra cent in benefits come retirement because of the aforementioned monthly benefit cap at full retirement age. Needless to say, lifting or removing the payroll tax cap to raise additional revenue is far trickier than most folks probably realize.
The $16,728 Social Security bonus most retirees completely overlook
If you’re like most Americans, you’re a few years (or more) behind on your retirement savings. But a handful of little-known “Social Security secrets” could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more… each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we’re all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.