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The Reason Why Social Security Can't Go Bankrupt

By Sean Williams – Updated Oct 23, 2016 at 7:16AM

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Despite a long-perpetuated myth, Social Security will be paying out benefits for many future generations of retirees.

Image source: Getty Images.

There's no two ways about it: Social Security is the most important social program in the country for seniors. According to statistics from the Social Security Administration, more than three in five seniors rely on Social Security to generate at least half of their monthly income. Without Social Security income, a number of seniors would probably be struggling to make ends meet.

America's most important social program is in trouble

Unfortunately, this vital program is itself not on solid footing. Baby boomers are retiring in greater numbers, which is pushing the worker-to-retiree ratio lower, while at the same time Americans are living longer than ever. Both of these significant demographic shifts are weighing on Social Security.

According to the latest report from the Social Security Board of Trustees, the Old-Age, Survivors, and Disability Insurance Trust (OASDI) is on track to switch from a cash inflow to a cash outflow beginning in 2020. By 2034, the OASDI is forecast to have exhausted its more than $2.8 trillion in spare cash. This isn't a rosy scenario for baby boomers who may be planning to lean heavily on income from Social Security during retirement.

In fact, the grimness of Social Security's outlook led 51% of millennials in a 2014 survey from Pew Research Center to predict that that the program is headed toward bankruptcy. By this account, slightly more than half of the millennials surveyed don't expect to receive a dime from Social Security once they retire. This expectation of an imminent bankruptcy for Social Security at some point in the future is one of Americans' greatest fears. It's also one of the longest perpetuated myths.

Image source: Getty Images.

Social Security won't go bankrupt -- here's why

Social Security simply can't go bankrupt. The design of the program ensures that it can't.

Revenue from the Social Security program is currently generated three ways.

The smallest source of revenue generation for Social Security is the taxation of benefits. You may not be fully aware of this point, but if you earn too much money while claiming Social Security income, the Internal Revenue Service will tax a percentage of your benefits. Individuals earning between $25,000 and $33,999 and married filers between $32,000 and $43,999 can have half of their Social Security benefits exposed to federal taxation. Earned income above $34,000 for individual tax filers and $44,000 for couples subjects 85% of their benefits to federal taxation. Of the $920.2 billion paid out by the Social Security Administration in 2015, 3.4% came from the taxation of Social Security benefits.

Second, interest earned on the aforementioned $2.8 trillion in spare cash generates funding for the program. The OASDI's spare cash is invested almost entirely in special issue bonds from the federal government with a small amount invested in certificates of indebtedness. With lending rates hovering near historic lows, most newly issued bonds have interest rates that are well below 3%, or even 2% in some cases. Last year the Social Security program generated 10.1% of its revenue from the interest earned on its spare cash. According to the Trustees Report, this cash, and the interest earned from it, could be gone by the year 2034.

Image source: Social Security Administration. 

However, the majority of the program's revenue (86.4%) is generated from the payroll tax. The payroll tax is a 12.4% tax on workers' earnings paid in its entirety by the self-employed and often split down the middle between employers (6.2%) and employees (6.2%). This 12.4% payroll tax is collected on earned income between $1 and $118,500. This latter figure is adjusted annually in step with the national inflation rate, while earned income above and beyond $118,500 is free and clear of being taxed by the Social Security Administration.

The payroll tax is precisely why Social Security will never go bankrupt. Just because the current benefits trajectory isn't sustainable over the long-term doesn't mean that payroll tax revenue stops rolling in. As long as people continue to work, the program will continue to collect payroll tax revenue. It's quite possible that a benefits cut could be possible by 2034 or sooner, but Social Security can operate in perpetuity as a budget-neutral program that pays out in benefits what it receives in revenue. Bankruptcy simply isn't possible.

The most important question

Instead, the most important aspect of Social Security the American public and Congress should be focused on is how best to fix Social Security for current retirees and future generations of retirees. There are easily 15 solutions on the table to fix Social Security, but each has its drawbacks.

Raising the payroll tax earnings cap -- the aforementioned limit of $118,500 at which earned income no longer is subject to the payroll tax -- is questionably the most popular solution. Since most Americans make less than $118,500 and are being taxed on every dollar they earn, raising the payroll tax cap would wind up affecting only around one in 10 people. Of course, raising the payroll tax cap doesn't resolve the full scope of the budgetary shortfall, meaning further measures may need to be taken.

Image source: Getty Images.

Raising the full retirement age (FRA) is another popular option, albeit far and away a second-place option behind raising the payroll tax cap. Your FRA is the point at which you become eligible to receive 100% of your Social Security benefits. Retiring before you reach your FRA means accepting less than 100% of your monthly benefit for life, while retiring later would yield a monthly benefit in excess of 100%.

Raising the FRA from its current trajectory of 67 years old for people born after 1960 to, say, 69 or 70 years would presumably encourage people to work longer and generate extra income for Social Security. Unfortunately, it would also punish seniors who have no choice but to file for benefits as soon as possible (age 62) with a highly reduced monthly payment.

Harsher fixes exist as well, such as raising payroll taxes on everyone right now or freezing benefits at 2016 levels for all future retirees. Both ideas would fully cover the budgetary shortfall, but they'd either put an increased burden on workers or crush future retirees by stripping away their inflationary raises.

Needless to say, the best path to fix Social Security is still up for debate.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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