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Social Security - Thoughts for the Future

During much of this Summer I have written several articles regarding Social Security.  Anyone who has followed this series should have a better idea as to why the program is facing challenging times ahead.  This week, I would like to focus on some of the questions we will have to ask ourselves and the issues we will be facing as we try to come to grips with this program.

Regardless of political hoopla, there are really only three ways to maintain this program.  Throughout the past, most of these methods have been implemented in one way or another.  Here are the three methods:
1) Increase Revenue - Obviously if revenue was increased for the Social Security program it would help alleviate future deficits.  This approach has been one of the main ways the program has survived as long as it has.  As I've illustrated in previous articles, revenues have increased steadily throughout the years.  The problem with this approach to alleviate future problems with the Social Security program is a question of pure economics and demographics.  We are already pumping an astounding 12.4% of each worker's payroll into the Social Security program.  (6.2% from employees pay and the same amount paid for by the employer…..self-employed individuals pay the full shot).  Regarding demographics, we all know that the baby boomers are approaching retirement.  I have explained that the number of workers per retiree is dropping and that we are currently on a “pay as you go” system.  Given these two factors, it appears that an increase of revenue would not be a viable solution to the problem.
2) Reduction in Benefits - This has occurred several times in the past as I pointed out in previous articles.  One way this can be accomplished is to increase the retirement age even more.  This might make sense as life expectancy continues to increase.   Another way would be to reduce (or even eliminate) Social Security benefits for more affluent retirees.  This too has been partially implemented.  The system is already designed so that people who contribute less into the program receive more (proportionally) in benefits than does a higher wage earner.  Eliminating benefits for more affluent workers would certainly be controversial but if saving the SS program is a priority a tough choice like this may have to be made.  Another indirect way to reduce benefits would be to tax more SS benefits.  This would increase inflows to the Government that could be earmarked for use in paying SS benefits.
3) Increasing the Yield on Trust Fund Assets - This approach has NOT been implemented in the past.  If we took at least part of the trust fund's reserves and actually invested it, this could make some difference in the long run.  The problem is (as previously mentioned) we are on a “pay as you go” system.  If proceeds were for example invested in the stock market, a market downturn would in fact decrease the surplus in the short run.  Obviously the market has always created positive long-term results but the key words here are long-term.  Many people do not feel comfortable having any excess funds invested in the stock market. 
4) Individual Accounts - Finally there are many proponents who would enjoy having the chance to invest part of their required contributions into the SS program.  This would be very similar to your 401(k) at work.  Participants themselves, proponents say, could take ownership in the SS program and allow the potential for much higher returns.  Implementing such a policy would have its disadvantages too such as setting up the administration of such a massive change in policy and educating the public on how to invest their share of SS contributions.

If you've read my articles on Social Security in these past few weeks, I hope it has become apparent this program has had an interesting past!  SS has certainly faced problems before and those problems have been worked out in one form or another.  The challenges we face now however are much more severe due to increasing longevity, the baby boomers coming of retirement age, and not investing trust fund surpluses.

Without question, we as a Nation will have to make very tough choices in the future in order to maintain the viability of the Social Security program.  Making these choices will require sacrifice and quite frankly not everyone will be pleased with the changes that will have to be made.  In any case, it would be for our benefit to deal with these issues sooner rather than later.

History of Social Security - Part II     Back to top

Last week, I began a series on Social Security by explaining how it all began back in 1935.  I continued on with the history of this program from its beginning through 1954.  This week, I'll continue on with Social Security's history from where I left off to where we are at today.  It's my belief that a brief understanding of Social Security's history will help us face today's problems and more important, work on solutions.

In 1961, the retirement age was reduced to 62 with reduced monthly benefits for those wishing to retire early.

In 1972 there were several changes to the program:
1) Minimum monthly benefit was established - For workers who did not contribute as much into the program the result of a minimum benefit has the effect of having to pay out more in proportion to what the worker put into the program throughout his/her working years.
2) Automatic Cost of Living Adjustments (COLA) were instituted.
3) Monthly benefits were significantly increased for those workers waiting until age 65 to retire.
4) System for automatic increases in the amount of earnings subject to Social Security was developed.

The above changes made the cost of running this program substantially more; much in the same way as the changes I discussed in last week's article.  In fact, in 1975 the Treasury Department reported that unless something different was done to the program, payroll taxes collected would be insufficient to meet program payments by 1979!

In response to this development, Congress increased the tax rate, reduced benefits, and made the automatic adjustment to the amount of earnings subject to Social Security independent of the Cost of Living Adjustment.  These steps were enough at the time to avert a potential failure in the Social Security program.

In 1983, realizing the fragile state of Social Security, President Reagan formed a Commission to study the problems and come up with potential solutions.  As a result of this study, Congress implemented the following changes:
1) Taxed some social security benefits - Before this change, benefits were not taxed.  Now some benefits are taxed if income is above a prescribed level.
2) Included Federal employees in the definition of “employees” for Social Security payroll tax purposes and
3) Scheduled increases in the normal retirement age (that took effect after the year 2000). For example, normal retirement age for anyone born in 1960 and later is 67.

Attached is a summary of Social Security and Medicare rates from 1937 through the current year.  Please note that the Social Security tax rate is the gross rate.  For example, the current rate for Social Security for 2006 is 12.4%.  This represents the total amount of an employee's pay that goes into social security.  For employees, one-half of this amount is deducted (6.2%) is deducted from their paycheck and the employer pays the other 6.2%.  Counting Medicare, a total of 15.3% is paid for most people's pay and that's just for Social Security and Medicare.  When you take income taxes, sales tax, hidden taxes (such as the amount of tax on the gas you purchase, etc.), the real “tax” we pay is quite high.  Many people do not realize this.

Next week, I will continue on with my series on Social Security.  In particular, I'll go over some of the challenges we are now facing and discuss potential solutions.

History of Social Security - Part I     Back to top

This week, I would like to begin a series on Social Security by first discussing its history.  Being familiar with the history of this program will help us better understand how Social Security works today and why we as a nation are facing major challenges with this program.

Passage of the Social Security Act (SSA)- This Act was passed in 1935 as a result of recommendations by the Committee on Economic Security.  This committee was created by then President Franklin D. Roosevelt.  The main reason for all this of course was the devastating effects of the great depression.

The original program had the following characteristics:
1) Paid monthly benefits to individuals 65 or older and no longer working
2) Amount was paid to the primary worker upon retirement
3) Benefits received were based on the individual's payroll tax contributions.
4) Unemployment insurance, aid to dependent children, and grants to States for medical care.  (There was no separate Medicare)

It is important to point out that upon its creation Roosevelt's intention was for Social Security to be an Insurance Program to protect against old age and disability.  Workers would pay insurance premiums through payroll tax deductions.  Roosevelt specifically distained the idea of reliance upon welfare.  At the time, there were relatively few people who lived long enough to collect any significant benefits.  After all in 1935, the average life span was only 67 years old.

Like most government programs, changes (which cost more money) began to occur almost immediately.  In 1939 Social Security was modified by including the following new benefits:
1) Spousal or Minor Children of a retired worker
2) Survivor benefits to the family in the event of premature death of covered worker

These changes were important because now instead of being an individual insurance-based plan, Social Security was practically changed overnight into a Family-Based program.  Also under these changes the payouts (which were originally designed to begin in 1942), were accelerated to begin in 1940.  The program grew in a very short time, to cover benefits for retirement, disability, premature death, and medical costs after retirement.

The next significant change occurred to this program in 1950 where a cost of living adjustment (COLA) was added to the program.  This was a one-time increase in benefits of 7.7%.  In 1952 (just 2 short years later), another COLA increase went into effect.  This time it was a 12.5% increase.

Social Security Taxation - Some Benefits can be Taxable     Back to top

For most people on social security, benefits are not taxable.  For people who have other income (earned or unearned), some of Social Security benefits might be subject to taxation.

Like many other things in the tax rules, it's a little difficult to determine whether your benefits might be taxable.  A quick way to help you determine this is to do the following:

Add one-half of total Social Security benefits you received to all your other income including tax exempt interest and other exclusions from income.
If the total is above $25,000 (Single) or $32,000 (Married Filing Jointly) then some of your Social Security Benefits are taxable.

If part of your benefits are taxable, how much of it is taxable depends on the total amount of your benefits and other income.  If you have a higher income then more of your Social Security benefits will be taxable and vice versa.

The general rule of thumb is that 50% of your benefits will be taxable.  This percentage however can be 85% if either of the following situations applies to you:

The total of one-half of your benefits and all your other income is more than $34,000 (Single) or $44,000 (Married Filing Jointly)
You are married filing separately and lived with your spouse at any time during the tax year.

There are several worksheets to figure your taxable benefits and these worksheets are in the instructions to the Form 1040.

Disability Income - Please note that these same rules also apply to Social Security disability and survivor benefits.  Many people are under the mistaken impression that these benefits are not subject to the rules regarding social security taxation. 

Lump-Sum Social Security Benefits - Much in the same way as regular Social Security, lump sum benefits must be applied to a similar test to determine if some of these benefits are taxable.  There are two ways to report this income.  One way is to report the total lump sum in the year you receive it OR (if it will reduce your overall tax liability) you can apply portions against prior year's income to which the Social Security benefits relate.

IRS Publication 915 discusses the area of Social Security and equivalent Railroad Retirement Benefits.

Social Security - How Surpluses are “Invested”     Back to top

This week, I am going to focus on the way in which Social Security (SS) reserves are handled.  As I've mentioned in a previous article, we have had reserves for several years now.  Reserves are created when SS receipts (amounts taken in from SS taxes) exceed the amount paid out in SS benefits.  This is expected to continue for about another 12 years or so.  After that SS expenditures are expected to exceed revenues coming into the program and a deficit will be created.

I've also mentioned how the SS program is currently a “pay as you go system”.  This means that benefits paid into the program are immediately paid out.  Any excess goes into the general fund of the U.S. Government and used to finance Government expenditures.  In return, the Social Security Administration receives a piece of paper (I.O.U.) from the Federal Government promising to pay it back along with a relatively low rate of interest.

The Government (when it pays back principal and interest) does so from its general fund and/or by issuing new debt (rolling over debt for debt).  Unlike a normal investment where invested proceeds are used to produce income (i.e. a return on your money), SS reserve funds are given to the Government in exchange for a piece of paper.  Proceeds are then used (spent) on government expenditures.  This is very different from regular investments where proceeds are invested into something that produces (or has the potential to generate) money.

The only real asset the Government has is its ability to tax the public.  Any payback of debt the Government incurs comes from the same source as all other sources of Government revenue; taxes collected from individuals and businesses.  It is important to note also that many Government expenditures do stimulate the economy and as a result increases future tax revenue the Government receives.

The Social Security Trust Fund then is really just the sum of all the I.O.U.s that the U.S. Government owes to Social Security.  The principal has not been “invested” but rather used up along with all other government expenditures.  This is a surprise to many people who think excess SS funds are invested into hardcore assets that produce revenue and are accessible.  This is not the case.
Many politicians speak of the SS trust fund as if it were a true investment; one that we can tap into at any time.  Many politicians focus on this number.  In reality, this number is relatively meaningless as I've just explained.  The bottom line is that reserves are not readily at hand to make up for the difference (deficit) that will occur in around 12 years when benefits paid out will exceed SS tax revenues coming in.

Understanding this very important concept helps us all gain a more comprehensive understanding of the SS program, especially as it relates to potential solutions.

Social Security - Benefit Reductions & Taxation     Back to top

Last week I wrote on Social Security and included a chart showing how much benefits can decrease by taking early retirement.  This decrease in benefits continues throughout one's lifetime.

It should be noted that the percentage of workers claiming social security when they reach age 62 is declining. Up until now a fairly consistent share of workers (60% of women and 52% of men), have taken early retirement under social security.

This makes sense for many reasons:
1) People are living longer, healthier lives.
2) People are working longer than past few generations.
3) People realize they must make the most out of their retirement income.

It only makes sense that people's behavior change with the times.  Delaying social security makes sense if you're able to work longer because of higher monthly benefits when you finally do retire.  I should also note that survivors whose spouses claim social security benefits at a later date benefit more than they otherwise would.

Further reduction in benefits:  For those taking early retirement, an even further reduction in benefits may take place if you continue working.  This reduction will take place until after you've reached full-retirement age.  The reduction is based on earnings over an “exempt” amount.  To make matters even more complicated, the amount of your exemption depends upon whether you've reached full-retirement age in the current year or if the current year is prior to the year of your full-retirement age.  There is a $1 social security benefit reduction for every $3 of social security earnings above your exempt amount in the first case.  For all years prior to the year of full-retirement age, there's a $1 reduction for every $2 of social security benefits over the exempt amount.

One good thing is that the government does take these reductions into consideration later on and will actually do some recalculating for higher future benefits in the years after reaching full-retirement.  However as you can see, it's generally not a wise choice to take early social security benefits given the many factors we've discussed unless you absolutely have to.

Taxation of Social Security Benefits - Regardless of when you take social security, it's important to discuss how they may be taxed.  Again, this calculation is not straight forward.  Basically if you're modified adjusted gross income + one-half of social security benefits exceeds $25,000 ($32,000 for married filing jointly), the excess is taxed.  For purposes of this calculation, modified adjusted gross income is basically your adjusted gross income + any tax-exempt bond interest.  (Having exempt bonds may exempt you from Federal taxes but not on having social security taxed)!

As you can see, it's important to weight all relevant information to see when you might start taking social security benefits.  Factors such as age, health status, desire to continue working, future income amounts, tax brackets, etc. all need to be taken into consideration.

Social Security - Should You Wait Until Full Retirement Age?     Back to top

As 78 million baby boomers approach retirement age, there are two very important decisions to make in regards to social security:
1) When to start taking benefits?
2) If benefits are started before retirement age, will I be further penalized if I continue working?
    (In other words, should you continue to earn income)?

This week, I will address the issue of when to take benefits and I'll continue on from here for future articles. 

When should you start taking benefits?  Right now according to the Social Security Administration, about 73% of retired worker beneficiaries elect to begin collecting social security benefits before reaching full retirement age.   Perhaps the easiest way to see how much your monthly benefit might be reduced is to take a look at the following graph:
Year of Birth 1. Full (normal) Retirement Age Months between age 62 and full retirement age     At Age 62 2.
A $1000 retirement benefit would be reduced to The retirement benefit is reduced by 3. A $500 spouse's benefit would be reduced to The spouse's benefit is reduced by 4.
1937 or earlier 65 36 $800 20.00% $375 25.00%
1938 65 and 2 months 38 $791 20.83% $370 25.83%
1939 65 and 4 months 40 $783 21.67% $366 26.67%
1940 65 and 6 months 42 $775 22.50% $362 27.50%
1941 65 and 8 months 44 $766  23.33% $358 28.33%
1942 65 and 10 months 46 $758 24.17% $354 29.17%
1943-1954 66 48 $750 25.00% $350 30.00%
1955 66 and 2 months 50 $741 25.83% $345 30.83%
1956 66 and 4 months 52 $733 26.67% $341 31.67%
1957 66 and 6 months 54 $725 27.50% $337 32.50%
1958 66 and 8 months 56 $716 28.33% $333 33.33%
1959 66 and 10 months 58 $708 29.17% $329 34.17%
1960 and later 67 60 $700 30.00% $325 35.00%
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1. If you were born on January 1st, you should refer to the previous year.
2. If you were born on the 1st of the month, we figure the benefit as if your birthday was in the previous month. You must be at least 62 for the entire month to receive benefits.
3. Percentages are approximate due to rounding.
      4. The maximum benefit for the spouse is 50% of the benefit the worker would
           receive at full retirement age. The % reduction for the spouse should be applied
          after the automatic 50% reduction. Percentages are approximate due to rounding.

You will notice that the younger you are, the more you are being penalized for retiring early (as compared to older counterparts).  This penalty occurs in two ways.  First the “Normal Retirement Age” continues to increase the younger you as well as the amount of benefit reduction.  To put it concisely, older people got a better deal in regards to social security compared to the deal younger people are receiving today.  To illustrate, let's take someone born in 1937 or earlier and compare that to someone born in 1960 or after.  The normal retirement age is 65 and 67 respectively.  Benefit reductions are 20% and 25% (worker and spouse) compared to benefit reductions of 30% and 35% for those born after 1960.

As most of us know, Social Security faces major challenges.  (I have written on these challenges in a series of articles in the past).  To be sure, even more dramatic changes will occur, the intentions of which is to make Social Security viable for the future.

Bob Tackabury is owner of Robert L. Tackabury, CPA 2556 Rt. 12B, Hamilton, NY 315-825-0255 and is an Investment Registered Representative.  Securities offered through IBN Financial Services, Inc., 404 Old Liverpool Rd.Liverpool, NY 13088.  315-652-4426. 
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