How Social Security Works: What You Need to Know

How Social Security Works: What You Need to Know

Social Security is a cornerstone of retirement planning in the United States, yet many people don’t fully understand how it works. When did it start? How are benefits calculated? Will it run out of money? And why doesn’t the U.S. have a pension-like system similar to other countries? These are common questions, and the answers are crucial for anyone planning their financial future.

In my experience, clients often view Social Security as both a mystery and a lifeline. Once people understand its history, mechanics, and potential pitfalls, they feel more confident incorporating it into their broader retirement strategies.

By the end of this article, you’ll learn:

• The history of Social Security and recent reforms.

• How benefits are calculated and what you can expect to receive.

• How the U.S. compares to other countries with national pension systems.

• Why Social Security isn’t “running out of money” and how funds are managed.

• Practical strategies to maximize your benefits.

Why Listen to Me?

As a CERTIFIED FINANCIAL PLANNER™ professional, I’ve helped many clients navigate the complexities of Social Security. From understanding how benefits fit into a retirement strategy to deciding when to start claiming, I’ve guided people through the choices that shape their financial futures.

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Key Takeaways

• Social Security was introduced in 1935 as part of President Franklin D. Roosevelt’s New Deal.

• Recent reforms, including the Social Security Fairness Act signed into law on December 29, 2022, have addressed inequities for public sector workers like teachers, firefighters, and police officers.

• Monthly benefits range from a few hundred dollars to over $4,000, depending on your earnings and when you claim.

• While Social Security faces funding challenges, options like raising taxes or adjusting benefits can ensure its sustainability.

• Funds are invested in low-risk Treasury bonds, earning stable but modest interest.

The History of Social Security

Social Security was established in 1935 during the Great Depression. At the time, poverty among older Americans was widespread, and the program aimed to provide a safety net for retirees, disabled individuals, and survivors of deceased workers.

How It Works

Social Security is funded through payroll taxes under the Federal Insurance Contributions Act (FICA). Workers and employers each contribute 6.2% of wages (up to the annual income cap of $160,200 in 2023). These contributions go directly to current beneficiaries in a pay-as-you-go system.

Recent Reforms for Public Sector Employees

On December 29, 2022, the Social Security Fairness Act was signed into law to address benefit inequities for teachers, firefighters, police officers, and other public sector workers. This legislation repealed two controversial provisions:

1. Windfall Elimination Provision (WEP): Previously reduced benefits for retirees who received pensions from jobs not covered by Social Security. Its repeal ensures full benefits.

2. Government Pension Offset (GPO): Reduced spousal or survivor benefits for individuals with a government pension. Its repeal restores full eligibility for these benefits.

Impact: Nearly 3 million public employees are expected to see increased Social Security benefits, ranging from an additional $360 to $1,190 per month, depending on their circumstances.

How Are Social Security Benefits Calculated?

Social Security benefits are based on your lifetime earnings and the age at which you claim benefits.

Step 1: Average Indexed Monthly Earnings (AIME)

• The Social Security Administration calculates your AIME using your 35 highest-earning years, adjusted for inflation.
  

Step 2: Primary Insurance Amount (PIA)

• Your PIA is the amount you’ll receive if you claim benefits at your full retirement age (FRA), which is 66 or 67, depending on your birth year.
  

Step 3: Claiming Age Adjustments

• Early Claiming: If you claim benefits at age 62, your monthly payments are reduced by up to 30%.
  
• Delayed Claiming: For every year you delay past FRA (up to age 70), your benefits increase by approximately 8%.
  

Will Social Security Run Out?

The idea that Social Security will “run out of money” often makes headlines, but the reality is more nuanced. The trust fund is projected to be depleted by 2034, but this doesn’t mean the program will disappear. Payroll taxes will continue to fund approximately 77% of benefits even without changes.

Source: Will Social Security Run Out?

Ways to Ensure Sustainability

1. Raising Payroll Taxes: A modest increase in the current 6.2% rate could generate billions in additional revenue.

2. Raising the Income Cap: Taxing wages above the current cap of $160,200 could significantly boost funding.

3. Adjusting Benefits: Measures like raising the full retirement age or reducing benefits for high earners could help balance the system.

Does Social Security Earn Interest?

Yes, Social Security funds earn interest. Surplus payroll taxes are invested in special-issue Treasury bonds, which are low-risk, government-backed securities. These bonds earned an average interest rate of 2.3% in 2022, ensuring stability but offering limited growth compared to higher-yield investments like stocks.

How Does Social Security Compare Globally?

Singapore’s Central Provident Fund (CPF)

Singapore operates a national pension system where contributions are invested in markets, creating individual retirement accounts. This system allows for potentially higher growth but comes with market risk.

Why Doesn’t the U.S. Have a Similar System?

The U.S. Social Security program operates as a pay-as-you-go system, with current workers funding current retirees. Efforts to introduce market-based investments have faced political and logistical challenges.

State-Based Programs

Some states, like California and Oregon, have introduced mandatory retirement savings programs for workers without access to employer-sponsored plans. These initiatives complement Social Security by encouraging additional savings.

Making the Most of Social Security

1. Decide When to Claim

In my experience, deciding when to claim benefits is one of the most critical decisions retirees face. Factors to consider include:

• Life expectancy

• Current income needs

• Other retirement savings

2. Coordinate with a Spouse

For married couples, coordinating claiming strategies can maximize lifetime benefits. For example:

• One spouse can claim early, providing income, while the other delays to maximize their benefit.

3. Supplement with Savings

Social Security alone isn’t enough for most retirees. I recommend contributing to a 401(k), IRA, or other retirement accounts to ensure a comfortable retirement.

FAQs

1. Are Social Security Benefits Taxable?

Yes, benefits may be taxable if your income exceeds certain thresholds. For example:

• Up to 50% of benefits are taxable for individuals with income over $25,000.

• Up to 85% is taxable for incomes over $34,000.

Source: Is Social Security Income Taxable