I had recently dropped a little article to help young adults or teams understand their paycheck. I didn’t realize the active conversation this would create among some readers and followers. Primarily around Social Security.
I’m going to break this into a couple different posts. In this first post, we’ll jam through what Social Security is and wow it works. We’ll then explore in a future post, what much of the discussion was about, what is the opportunity costs of contributing to Social Security.
Let’s get started! Here we go!
A Quick History
Let’s start with a quick baseline. The Social Security Administration is considered to be a foundational pillar of the United States’ welfare system. It was designed to provide financial support to retirees, disabled individuals, and survivors of deceased workers.
The program was established way back in 1935 in response to the economic devastation of the Great Depression. Its initial purpose was to alleviate poverty among the elderly, a pressing issue at the time, by providing a continuous income after retirement.
Over the years, Social Security has evolved and expanded to include disability insurance, survivor benefits, and Medicare, thereby broadening its scope to support a wider range of beneficiaries. The program is funded primarily through payroll taxes collected from workers and their employers.
Social Security operates on what is referred to as a pay-as-you-go basis. This is where today’s workers are funding the benefits of current retirees. Social Security has become a crucial component of American social policy, ensuring some sort of economic security for millions of people in their older years while in retirement.
How Social Security Contributions Work
For W2 employees, understanding how Social Security contributions work, and how these contributions translate into benefits upon retirement, is an essential piece of financial planning.
As we discussed in the previous article on Understanding Your Paycheck, Social Security is funded through Federal Payroll Taxes deducted from your paycheck. This collected under the Federal Insurance Contributions Act or FICA. If you are a W2 employee, you may notice a specific deduction on your paycheck labeled as “FICA.” or you can see my previous paycheck stub below. Mine was labeled both Social Security and Medicare Tax under the Federal Withholding. This deduction is your contribution to the Social Security system. Here’s how it breaks down:
Contribution Rate: For 2023, the Social Security tax rate is set at 6.2% for employees. This means that 6.2% of your gross income up to a certain limit (called the wage base limit) is deducted and paid to Social Security. For 2023, the wage base limit is $160,200, this means that income earned above this threshold is not subject to Social Security taxes.
Employer’s Match: Your employer also contributes an equal amount (6.2%) to Social Security on your behalf. Therefore, the total contribution to the Social Security system amounts to 12.4% of your earnings up to the wage base limit.
Self-Employment: If you’re self-employed, you’re responsible for the full 12.4%. But, keep in mind, you may deduct half of this contribution when calculating your taxable income.
As we mentioned earlier, these contributions fund the current beneficiaries of Social Security, operating on the “pay-as-you-go” system where the taxes paid by today’s workers are immediately used to pay today’s recipients.
We often hear, there isn’t enough Social Security for everyone, or it’ll run out when I reach retirement age. As we said, it actually doesn’t “run out” because the taxes you pay go into the Social Security are used to pay benefits to current beneficiaries. However, the Social Security Administration has stated it estimates that, based on current laws, it calculates that funds collected will be able to pay benefits in full and on time until 2034. In 2034, Social Security would still be able to pay about $800 for every $1,000 in benefits scheduled.
How the System Pays Retirees
When you retire, the amount you receive in Social Security benefits is determined by your earnings history, specifically the 35 years in which you earned the most, adjusted for inflation.
If you are over 18, It can be a good idea to create an account and track and validate your earnings and the taxes paid into Social Security and Medicare. You’ll see what you paid as well as your employer.
Okay, here’s how the system begins to pay retirees:
Earning Social Security Credits: You earn “credits” based on your yearly earnings. In 2023, you receive one credit for each $1,510 of earnings, up to a maximum of four credits per year. To qualify for retirement benefits, you need to have earned 40 credits, equivalent to 10 years of work.
Benefit Calculation: The Social Security Administration does some crazy witchcraft math and calculates what’s called the AIME, or Average Indexed Monthly Earnings from your 35 highest-earning years. Then, it applies a formula to determine what’s called your Primary Insurance Amount or PIA, which is the basis for your retirement benefit.
Retirement Age: The full retirement age varies depending on your birth year, gradually increasing from 65 to 67 for those born in 1960 or later. You can start receiving benefits as early as age 62, but taking benefits before your Full Retirement Age results in permanently reduced monthly payments. Conversely, delaying benefits past your Full Retirement Age can dramatically increase your monthly benefit, up to age 70.
Cost-of-Living Adjustments: Benefits are adjusted annually for inflation, ensuring that the purchasing power of Social Security benefits does not erode over time.
You’ll Need More
Keep in mind, Social Security is not meant to be your only source of income in retirement. You will likely need other savings, investments, pensions, or retirement accounts to live comfortably in retirement. On average, Social Security benefits will replace about 40% of your annual pre-retirement earnings, although this can vary based on each person’s circumstances.
For me, personally, I haven’t used my social security benefit in my planning. The entire focus of this blog and learning personal finance and investment principles was to increase my Individual Retirement Accounts, Employer 401ks, Health Savings Accounts, Brokerage Investment Account and Real Estate Investments. For me, My social security benefits will most likely be gravy on the top once I reach retirement age.
The Importance of Social Security
However, I do understand the importance of Social Security, and that it does provide a financial foundation for millions of Americans in retirement, and benefits if disabled. This is a program that offers a guaranteed income that adjusts for inflation and lasts for life.
While it’s not intended to be the sole source of income in retirement, Social Security plays an important role in reducing poverty among the elderly and aging population. It can provide some sort of financial security.
For those W2 employees, understanding the structure of Social Security contributions and benefits can be crucial for long-term financial planning. By appreciating how your contributions today support the system and how you will benefit in the future, you can better plan for a secure retirement.
Social Security is a crazy complex system, but at its core, it’s about providing security and stability for Americans when they need it most. Through the collective contributions of workers across the country, the system supports retirees, disabled individuals, and families of deceased workers. As you navigate your career and plan for retirement, keep in mind the role that Social Security can play in your financial future.
Horns Up, Friends! \m/ \m/ Stay tuned for the next post!
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