http://www.heritage.org/Research/SocialSecurity/bg1827.cfmMarch 2, 2005by David C. JohnBackgrounder #1827Social Security is probably the most popular federal program, yet most people know almost nothing about it. In practice, Social Security’s complex benefit formulas and rules make it difficult for people to understand how their retirement benefits will work.This paper explains what Social Security is and how it works. The first section explains what Social Security is and which programs are and are not part of Social Security. The second section explains the payroll taxes that mainly finance Social Security and how they are paid. The third section explains what Social Security’s trust funds are and are not. The fourth and longest section discusses how Social Security benefits are calculated and who is eligible to receive them. A companion paper will discuss the fiscal problems facing the current system and why changes are necessary. All of the information contained in this paper comes from Social Security Administration (SSA) sources.What Is Social Security?Social Security is the most popular government program and touches the life of every worker in America, but most people know little or nothing about how it operates. The following discussion explains what Social Security is and how it operates.Social Security’s Major Programs. While most discussions focus only on Social Security’s retirement program, Social Security actually consists of three major programs, all of which are administered by the Social Security Administration. Specifically:· Retirement. Social Security’s retirement program provides a lifetime monthly income for qualified workers once they reach their full retirement age. Depending on when they were born, that age ranges from 65 to 67. The amount of retirement benefits that a worker receives depends on his or her income while working. Workers also have the option of receiving a lower monthly income starting at age 62.· Survivors. Social Security’s survivors program provides a monthly lifetime income to the surviving spouse of a deceased worker once he or she reaches retirement age. The amount of the monthly benefit depends on both spouses’ income while they were working. The survivors program also pays benefits to children under the age of 18 and the surviving spouse caring for them. Unless they are disabled, children’s benefits end when the last child either reaches age 18 or graduates from high school, whichever is later.· Disability. Social Security also pays lifetime monthly income to workers who are disabled and, in some cases, to their spouses and children under the age of 18. These benefits depend on the worker’s earning history.Once they have worked and paid Social Security taxes for the required 40 quarters, they are fully qualified to receive Social Security retirement benefits. If workers have paid Social Security taxes for a certain number of quarters in the recent past,[1] they are also qualified to receive disability benefits and to have survivors benefits paid to their spouses and to their children who are under the age of 18Disability benefits are paid to workers who have been disabled for at least one year. In order toqualify, a worker must have paid Social Security taxes within the recent past. “Disabled” in this case means unable to perform any substantial gainful work due to severe physical or mental impairment. Determination of eligibility is based on medical evidence and made by a government agency in the state in which the worker lives.There is no requirement that an individual must be an American citizen to qualify for Social Security. While employers are required by other laws to ensure that anyone they hire is either a citizen or a legal immigrant, foreign nationals can earn Social Security credits with a valid Social Security number.Supplemental Security Income. The Supplemental Security Income (SSI) program is not part of Social Security. Even though the Social Security Administration administers SSI, the program is paid for with general tax revenues. No Social Security payroll taxes are used to pay for SSI. SSI helps aged, blind, and disabled people who have little or no income. It provides cash to meet basic needs for food, clothing, and shelter. To get SSI, a worker must be blind, disabled, or at least 65 years of age.Medicare. Medicare is a federal program that helps to pay for older Americans’ health costs. Some people incorrectly consider Medicare to be part of the Social Security system because taxes that finance part of Medicare are lumped in with those that pay for Social Security. However, Medicare is also financed by premiums and general revenue, and it is not administered by the Social Security Administration. For these reasons, Medicare is not considered part of Social Security.FICA. The taxes that pay for Social Security’s programs are confusing to most people. On most workers’ paychecks, the taxes that pay for both Social Security and Medicare are lumped together under the term “FICA” (Federal Insurance Contributions Act). Even the amount under FICA is misleading because it shows only half of the taxes paid on the worker’s behalf.Payroll Taxes and AmountsUnlike most other government programs, Social Security (like Medicare) is funded through explicit taxes that are not supposed to be used for any other purpose. These taxes are based on a worker’s earned income and deducted from his or her paychecks. For that reason, Social Security taxes are often referred to as “payroll taxes.” These payroll taxes are in addition to any income taxes that the worker must pay.Separate payroll taxes finance Social Security’s retirement and survivors benefit program, Social Security’s disability benefit program, and Medicare; yet the three are often lumped together as one line item on a worker’s pay stub. The two Social Security taxes are paid only on income up to a certain annual amount. Medicare taxes are collected on all earned income.In 2005, workers and employers will pay payroll taxes totaling 15.3 percent of the first $90,000 of income and 2.9 percent of income above that amount. The $90,000 dividing line is called the “earnings limit”—sometimes referred to as the “wage cap.” Of that 15.3 percent total, 10.6 percent of income pays for Social Security’s retirement and survivors program, and 1.8 percent pays for Social Security’s disability program. The remaining 2.9 percent is used to pay for Medicare programs, but the Medicare taxes are not subject to the earnings limit. In other words, Medicare taxes are collected on all of a worker’s earned income, not just the first $90,000.The worker and the employer each pay half of the payroll taxes. The self-employed pay both portions.FICA Defined. The paycheck stubs from most employers do not show the individual amounts that the worker pays for Social Security and Medicare. Instead, these taxes are lumped together and shown as a deduction for “FICA.”The Federal Insurance Contributions Act is the part of the Internal Revenue Code that gives the federal government the authority to collect the payroll taxes that pay for the Social Security programs and part of Medicare. The name implies that the taxes for these programs are actually contributions to a social insurance system. In reality, however, they are nothing more than taxes, and it would be more honest to refer to them as such.Matching Deductions by the Employer. In most cases, only half of the Social Security taxes that a worker pays are shown on the paycheck stub. Employers also pay an equal amount of payroll taxes on the worker’s behalf. As far as the employer is concerned, these additional taxes are part of the worker’s pay. Even though the worker never sees this income, the employer actually pays $10,765 for each $10,000 the worker earns ($10,000 in wages and $765 in payroll taxes). If that worker were not employed, the employer would not be required to pay the $765 in taxes.If this money was not paid to the government as payroll taxes, it could go to the worker as wages. For this reason, both halves of the FICA tax should be counted as being paid by the worker. Thus, instead of paying taxes equal to 5.3 percent of income for retirement and survivors benefits, the worker is actually paying 10.6 percent of income. The combined total is the true cost to each worker.Self-Employed Workers. This reality is clearly illustrated by self-employed workers, who must pay both the employer and the employee halves of the payroll taxes. Combining the payroll taxes for Social Security’s retirement and survivors program, Social Security’s disability program, and Medicare, the self-employed pay a total of 15.3 percent of income below $90,000 in 2005 and 2.9 percent of income above that amount. These payroll taxes are in addition to any income taxes.Retirement and Survivors Tax. The largest portion of FICA payroll taxes is used to pay for a worker’s retirement and survivors benefits. The taxes pay for both the monthly benefits to workers who have retired and the monthly benefits (after the worker’s death) to their surviving spouses and children (under the age of 18). The worker and employer each pay 5.3 percent for a total of 10.6 percent of income up to the earnings limit for these programs. These taxes go into the Old- Age and Survivors Insurance (OASI) trust fund.Disability Tax. Taxes equal to 1.8 percent of income (up to the earnings limit) go into the Disability Insurance (DI) trust fund and pay monthly benefits to workers who are unable to work due to a long-term physical or mental disability. As with all payroll taxes, half of the amount (0.9 percent of income) is deducted from the worker’s pay, and the employer pays the other half on the worker’s behalf.The Earnings Limit. In 2005, Social Security taxes will be collected on only the first $90,000 that a worker earns. This figure is known as the “earnings limit” and is adjusted each year. Social Security benefits are paid only on the amount of income that is subject to the Social Security payroll tax. Thus, in Social Security’s eyes, both Michael Jordan and Bill Gates earn $90,000 per year regardless of their actual incomes, and their Social Security retirement benefits will reflect this.The earnings limit protects Social Security from having to pay benefits on Bill Gates’s entire income. It allows the program to say that it covers all Americans without paying the very rich benefits that are much higher than those that go to average-income workers. Every October, Social Security calculates and announces the earnings limit for the following calendar year, based on the growth of wages in the economy. Wage growth is slightly higher than the rate of inflation (growth of prices).Developed as part of the 1983 Social Security reforms, this formula for increasing the amount of wages that are taxed for Social Security was supposed to cover 90 percent of the nation’s total wages. However, this proportion has gradually declined and is now closer to 85 percent.Income Taxes on Some Social Security Benefits. Since 1983, retirees with annual income above a certain amount have been required to pay income taxes on a portion of their Social Security benefits. The money raised through this tax is returned to either Social Security or Medicare.Retirees who earn between $25,000 and $34,000 and file as individuals may have to pay income taxes on up to 50 percent of their benefits. If they earn more than $34,000, they may have to pay income taxes on up to 85 percent of their benefits. Married retirees who earn between $32,000 and $44,000 may have to pay income taxes on up to 50 percent of their benefits, and if they earn over $44,000, up to 85 percent of their benefits may be taxable. These income thresholds are not indexed for inflation. Income taxes on Social Security benefits are paid at the same rates as on other types of earned income.Until 1983, all Social Security benefits were income tax free. In that year, Congress decided to tax 50 percent of the Social Security benefits of workers with total retirement incomes over $25,000 (for single retirees) because Social Security needed additional revenue. Congress justified the move by pointing out that the half of payroll taxes paid by employers can also be deducted from the employer’s corporate income taxes, while workers must pay income taxes on the amount of their check that is deducted as payroll taxes. Congress decided that since companies received a tax deduction on the amount of payroll taxes paid on behalf of their workers, Congress could recapture that tax benefit by assessing income taxes on half of some retirees’ benefits.In 1993, problems with financing Medicare led Congress to raise the proportion of Social Security benefits that is subject to income taxes to 85 percent for workers with incomes over $34,000 (for single retirees). The money raised from this tax goes to the Health Insurance trust fund.The Social Security Trust FundsMany people tend to think of their Social Security benefits as coming from an actual account, in their name, which contains cash or investments. People who believe this often point to the existence of the Social Security trust funds to justify their belief. However, this belief is fallacious for two reasons. First, Social Security has no individual accounts at all, other than a bookkeeping record of an individual’s yearly earnings and payroll taxes. Second, the program’s trust funds do not contain cash or saleable assets. They only represent the amount of Social Security taxes collected beyond what the program needs to pay current benefits.In reality, the Social Security trust funds contain nothing more than IOUs that have no value beyond a promise to impose higher taxes on future workers. The annual surpluses that many thought were being used to build up a reserve for baby boomers have been spent to fund other government programs or to reduce the government debt.The OASI and DI Trust Funds. Social Security has two trust funds: the Old-Age and Survivors Insurance trust fund and the Disability Insurance trust fund. These two trust funds are linked and are often referred to as a single trust fund, the Old-Age, Survivors, and Disability Insurance trust fund, or OASDI.Despite the fact that there are two trust funds, most of the estimates of Social Security’s finances use the combined OASDI trust fund, which is an important distinction. For instance, according to the 2004 trustees report, OASDI will begin to spend more than it takes in by 2018. Considered separately, the OASI trust fund is also predicted to begin to spend more than it takes in each year starting in 2018, but the DI trust fund will begin to spend more than it takes in starting in 2009.In addition to the two Social Security trust funds, there is a Health Insurance (HI) trust fund that partially funds Medicare. The HI trust fund is managed and invested in the same way as the OASI and DI trust funds but is outside the scope of this paper.
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