As of June, approximately 62.5 million Americans were receiving a monthly Social Security check, of which 69% were retired workers. For these retirees, Social Security's importance simply can't be overstated enough. 

The Social Security Administration finds that more than 3 out of 5 current retirees leans on the program for at least half of their monthly income, with a separate analysis from the Center on Budget and Policy Priorities estimating that over 15 million seniors are kept above the federal poverty level as a result of their guaranteed monthly check. If Social Security did not exist, we would likely be contending with an elderly poverty crisis.

A Social Security card wedged in between fanned cash bills.

Image source: Getty Images.

Yet for all that Social Security does for working Americans, the long-term disabled, and the survivors of deceased workers, there's very little known about how the program is funded, or how this funding could shift in the years that lie ahead. Today, we'll examine the program's three funding mechanisms, as well as how much those mechanisms are expected to contribute over the next 10 years.

Understanding Social Security's three funding mechanisms

First, let's start with the basics: How Social Security generates income to distribute to eligible beneficiaries.

Two Social Security cards lying atop a W2 tax form, highlighting payroll taxes paid.

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1. A 12.4% payroll tax on earned income, up to $128,400

The payroll tax is the workhorse of Social Security funding. It provides the bulk of revenue for the program by imposing a 12.4% tax on wage income of up to $128,400. This maximum taxable cap adjusts higher in step with the National Average Wage Index each year, with one caveat. If no cost-of-living adjustment (i.e., the annual "raise" beneficiaries receive that's supposed to match inflation) is passed along to beneficiaries, then the maximum taxable earnings cap also remains unchanged.

There are two noteworthy aspects about the payroll tax to point out here. First, it means those who earn in excess of $128,400 in wage income in 2018 will have some portion of their income exempt from Social Security taxation. It's been estimated by the Social Security Administration that $1.2 trillion in earnings escapes taxation each and every year. 

Second, it's worth pointing out that not everyone is paying this 12.4% tax on their wages. If you're employed by someone else or a large corporation, your employer covers half of your payroll tax responsibility, or 6.2%. This leaves most Americans with an actual obligation of 6.2%, up to $128,400. If you're self-employed, that's a different story. Then you'll owe the entire 12.4% tax on your first $128,400 in earned income.

A fanned stack of hundred dollar bills lying atop a neatly fanned pile of Treasury bonds.

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2. Interest income on the Trust's asset reserves

The second way Social Security generates income is by purchasing special-issue bonds and, to a far lesser extent, certificates of indebtedness from the federal government. The Social Security Administration uses the program's nearly $2.9 trillion in asset reserves, which have been built up over the past 35 years, to purchase these bonds.

Why not just let the cash sit there, you ask? The simple answer is that it would be losing value to inflation each and every year. By purchasing bonds, it allows the federal government a regular source of debt financing. Meanwhile, the program is receiving an average interest rate of 2.9% on its multiple different yields and maturities.

In short, the government borrowing money from Social Security is great news, because it means interest is consistently being paid into the program. Plus, since these bonds are backed by the full faith and credit of the U.S. government, there have been no concerns about the federal government's ability to make an interest payment or redeem a bond upon maturity.

A Social Security card next to IRS tax form 1040, a pair of reading glasses, and a twenty dollar bill.

Image source: Getty Images.

3. The taxation of Social Security benefits

The final puzzle piece is the taxation of Social Security benefits, which was introduced in 1984 following the sweeping reforms passed during the Reagan administration in the previous year.

The taxation of benefits applies to individual taxpayers whose adjusted gross income (AGI), plus half of their Social Security benefits, is higher than $25,000. For couples filing jointly, this figure rises to $32,000. Being subject to this tax allows the federal government to tax half of an individuals' or couples' Social Security benefits. In 1993, the Clinton administration added a second tier, allowing up to 85% of an individuals' or couples' benefits to be taxed if their AGI plus half of their benefits exceeds $34,000 or $44,000, respectively.

It's worth noting that since these income thresholds for taxation were passed in 1983 and 1993, they've never been adjusted for inflation. So a tax that once affected just 10% of all senior households now impacts an estimated 56%, according to the Senior Citizens League.

Here's how Social Security will be funded over the next 10 years

Now that you have the proper background on how Social Security is funded, let's take a closer look, courtesy of the 2018 Social Security Board of Trustees report, at how those funding mechanisms will work together to provide income to the program over the next decade.

Year Total Income Net Payroll Tax Contributions  Interest Income  Taxation of Benefits
2018 $1,001.1 billion $883.4 billion $83.1 billion $34.6 billion
2019 $1,061.4 billion $941.0 billion $82.2 billion $38.2 billion
2020 $1,112.5 billion $988.5 billion $81.8 billion $42.2 billion
2021 $1,167.0 billion $1,039.7 billion $80.9 billion $46.4 billion
2022 $1,233.7 billion $1,093.3 billion $79.8 billion $50.6 billion
2023 $1,282.8 billion $1,147.9 billion $79.8 billion $55.0 billion
2024 $1,345.5 billion $1,205.7 billion $80.0 billion $59.8 billion
2025 $1,407.9 billion $1,263.5 billion $79.4 billion $65.0 billion
2026 $1,484.6 billion $1,324.2 billion $79.1 billion $81.3 billion
2027 $1,549.6 billion $1,383.2 billion $78.3 billion $88.1 billion

Data source: Social Security Administration Board of Trustees report (2018), intermediate-cost model.

What you see here are estimates from the Trustees report of income generation between 2018 and 2027, based on the intermediate-cost model. Over the next decade, the Social Security program will jump from generating $1 trillion in income a year to $1.55 trillion by 2027.

But what's really interesting is the role that the individual funding mechanisms play. For example, you'll note that revenue from the taxation of benefits is expected to more than double from $34.6 billion in 2018 to $88.1 billion by 2027. Assuming that Congress doesn't adjust the income thresholds that subject beneficiaries to taxation, this implies that a greater number of individuals and couples will become subject to this tax in the decade to come. The taxation of benefits is projected to be providing 5.7% of total revenue by 2027, up from an estimated 3.5% in 2018.

Meanwhile, you've probably honed in on the slow decline in net interest income over the next decade. Despite the Federal Reserve tightening monetary policy, which should lead to higher special-issue bond yields, the Trust's asset reserves are expected to begin shrinking this year. In 2018, and each subsequent year, the Trustees have forecast a net cash outflow for Social Security, which would be its first since 1982. An estimated $702.4 billion is expected to disappear from its coffers over the next 10 years due to this cash outflow. With less excess cash to buy bonds, net interest income should fall. In fact, with the program's asset reserves expected to be depleted by 2034, this source of income could disappear entirely in the next 16 years.

As for payroll taxes, they'll become even more important by 2027. As you can see, 89.2% of all revenue in 2027 is expected to derive from payroll taxes, up from an estimated 88.2% in 2018. Payroll taxes are the saving grace that ensures Social Security can't go bankrupt.

Despite this, as noted, the program will begin running a deficit in 2018, and, with the exception of 2019, this net cash outflow will grow with each passing year. Though the payroll tax and the taxation of benefits will continue to bring in more revenue, the loss of interest income in less than two decades is expected to be yet another blow to an already challenged program.

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