For millions of retired workers, Social Security is a financial lifeline that they simply couldn't do without. Of the nearly 42 million retired workers receiving a monthly benefit check, some 61% rely on that check to account for at least half of their income. That's huge, and it demonstrates what a critical role Social Security plays in helping seniors make ends meet during retirement.
Last year, in 2016, Social Security collected $957.5 billion in income, of which $922.3 billion was disbursed primarily to retirees, as well as millions of disabled folks, and the survivors of deceased workers. All told, this marked the 33rd consecutive year that Social Security's asset reserves increased, following the passage of the 1983 Amendments that gradually increased both payroll taxes and Social Security's full retirement age.
How Social Security generates income
But have you wondered how exactly the Social Security program is able to generate nearly $1 trillion in income each year to disburse out to seniors, their families, the disabled, and survivors? Let's take a closer look at the three primary ways Social Security generates income.
1. Payroll tax
Without question, the largest source of income for Social Security, and as you'll see the main reason why the program can never go bankrupt, is the payroll tax. In 2016, $836.2 billion of $957.5 billion (87.3%) was derived from the payroll tax.
Payroll taxes, also known as FICA taxes, are the taxes workers pay on earned income toward Social Security and Medicare. The payroll tax for Social Security is 12.4% on earned income between $0.01 and $127,200, while Medicare is a flat 2.9% on all earned income, without exemption. However, most workers don't wind up facing the full brunt of Social Security's 12.4% tax. Instead, they're required to pay half, or 6.2%, while their employer covers the other half (the same is true for Medicare). Generally, it's the self-employed who get stuck with the full 12.4% bill for Social Security.
As a whole, roughly 90% of workers pay into Social Security on every cent they earn. This is a fancy way of saying about nine in 10 Americans earn less than $127,200 annually. Any earned income above this figure is free and clear of taxation. Why cap what income is taxed, you ask? Social Security's monthly benefit, at full retirement age, is capped at $2,687, so taxing $5 million in income doesn't seem "fair" if a person's max monthly payout is $2,687 as of 2017. That's why the maximum earnings tax cap exists.
The simple fact that this payroll tax exists ensures that Social Security cannot go bankrupt. As long as people keep working, payroll tax revenue will be collected as income for Social Security. This doesn't mean benefits couldn't be cut in the future, but it does mean you'll receive something from Social Security when you retire, as long as you're eligible for benefits.
2. Interest income on asset reserves
A second source of income for Social Security is the interest it earns on its asset reserves, which stood at $2.85 trillion at the end of 2016, and are expected to climb to around $3 trillion by 2022. In 2016, $88.4 billion in income (9.2%) was generated from interest earned on its asset reserves.
Special bonds are issued specifically for Trusts by the government, which allows this spare cash to earn a return for the program. A much smaller amount is invested into certificates of indebtedness.
But there are two wildcards at play here that retirees and workers should understand. First, the Federal Reserve can have an impact on Social Security. The U.S. central bank sets monetary policy, which in turn influences interest rates and bond yields. If the Fed continues to tighten its monetary policy, it should increase yields and allow Social Security's asset reserves to be invested in higher-yielding bonds, producing more interest income. That's actually some good news.
On the other hand, beginning in 2022 and extending to 2034, the Board of Trustees' latest report on Social Security forecasts that it'll be paying out more in benefits than it's generating in income. This means the base from which interest income is collected will begin to dwindle, culminating in its exhaustion by 2034. In other words, by 2034, this $88 billion in annual income will no longer exist.
3. Taxation of benefits
The final source of income generation for Social Security is the taxation of benefits. That's right, folks: your Social Security benefits may be taxable. In fact, statistics from The Senior Citizens League (TSCL) back in 2015 show that more than half of all seniors are paying tax on at least a portion of their benefits. Last year, $32.8 billion (3.4%) in income was derived from taxing Social Security benefits.
Back in 1983, when the last major overhaul of Social Security was undertaken, the federal taxation of Social Security benefits was introduced for well-to-do individuals. At the time, up to half of a beneficiaries' Social Security benefits could be hit with ordinary federal income taxes if they earned more than $25,000 as an individual or $32,000 as a couple filing jointly. This would be amended a decade later during the Clinton administration to add another tier that called for up to 85% of a beneficiaries' benefits to be taxed if they earned more than $34,000 as an individual or $44,000 as a couple filing jointly.
Now, here's the issue: The initial thresholds established in 1983 have never been adjusted for inflation. Thus, while the taxation of benefits affected only one in 10 senior households in 1983, it now impacts around 56% in 2015, according to TSCL.
Long story short, Social Security will be around for many generations to come thanks to the ways it generates income, but a rapidly rising beneficiary base and lengthening life expectancies may not protect current or future retirees from an eventual cut in benefits.
The Motley Fool has a disclosure policy.
More from The Motley Fool
Most Americans Made Poor Financial Decisions This Holiday Season
Were you one of them?
4 Ways to Save More in Your 401(k) in 2018
Annual 401(k) contribution limits are going up next year, and it pays to take advantage.
How 1 Senator Got a Bigger Tax Break for Families
Pressure led to an increase in a key tax credit. Find out more about it here.