Millions of retirees rely on Social Security as their primary source of income, even though benefits aren't very big. Sadly, current and future retirees counting on this money could be in for an unpleasant surprise within the next decade: Social Security benefit cuts could be coming.
While the most recent report from Social Security's trustees indicates the trust fund will be out of money in 2035, necessitating a 24% cut to retirement benefits, there's a really good chance funding will fall short before then, and cuts will have to occur sooner. Here are five key reasons why that's the case.
Image source: Getty Images.
1. Reduced payroll tax collection
Coronavirus-related business closures have left a record number of Americans without work. Even with both May and June data showing jobs were added, the unemployment rate still remains at 11.1%.
That's not good, and if coronavirus cases continue spiking, things could get worse. Sadly, with fewer people working, Social Security collects less payroll tax revenue. And a provision of the CARES Act enabling employers to delay payments on these taxes only serves to exacerbate the situation.
Since payroll taxes are a primary source of Social Security's revenue, reduced tax collection could mean big financial trouble is coming soon.
2. Higher-income retirees may pay less taxes on benefits
Taxes paid on benefits are another major source of revenue for Social Security. Around half of all beneficiaries pay them in a normal year, with some higher income seniors paying taxes on up to 85% of their benefits.
In 2020, though, there may be fewer retirees paying taxes, and the amount collected may be lower. That's because benefits aren't taxable until single retirees have countable income of at least $25,000 and married joint filers have countable income of at least $32,000. Countable income equals half of Social Security benefits plus other taxable income, and that "other" taxable income could be much lower this year for a number of seniors for myriad reasons including:
- Fewer seniors may be working and earning wages due to high unemployment among older workers during the COVID-19 crisis.
- Seniors may take smaller retirement account withdrawals if they suffered market losses due to COVID-19
- Retirees may opt not to take required minimum distributions this year since the CARES Act suspends them, or may take out less than would normally be required, thus reducing their taxable income.
If less revenue comes in from taxes on benefits, the trust fund is further depleted of income, putting future benefits at risk.
3. The trust fund will earn less interest
The Federal Reserve has set benchmark interest rates to near zero and all but promised they'll stay there through 2022.
This affects the interest Social Security can earn on the trust fund, which by law must be invested in special issue treasury bonds. The rate on those bonds had been on a steady decline from 2007 to 2018 and could fall again, threatening yet another key income source for Social Security.
4. Lower inflation could reduce long-term tax collection
By severely depressing economic activity, coronavirus is likely to put downward pressure on prices, likely causing weak inflation or even deflation. Unfortunately, when wage growth is suppressed due to a prolonged period of low inflation, Social Security's payroll tax revenue is once again reduced.
While Social Security's costs also fall during periods of low inflation because Cost-of-Living Adjustments (COLAs) are reduced and workers have a lower average wage upon which benefits are based, the reduction in revenue may not fully offset the costs of reduced tax collection -- especially as COLAs aren't really an accurate measure of inflation and as average wage is calculated over the 35 years in which workers earn the most.
5. Reduction in immigration further depletes revenue
The Trump administration has imposed new restrictions on immigration in response to coronavirus. The regulations, coupled with a poor economy and increased risks associated with relocation, will likely result in a major drop in the number of people coming to the U.S. to live and work.
Unfortunately, Social Security relies on legal immigration as migrant workers tend to be younger and pay into the benefits system for a long time. With birth rates falling, immigrant workers are also needed to help avoid a reduction in the worker-to-beneficiary ratio, which will only deepen the program's financial woes.
Don't get caught unprepared if your benefits are cut
A 24% cut to benefits would be an economic and political disaster, and it probably won't happen. But that doesn't mean you can count on receiving your full benefits. If lawmakers come to a compromise solution that shores up the program's finances, it will probably involve at least some type of reduction in the size of the checks future retirees receive.
With benefits already too small to be your sole source of retirement income, you'll need even more supplementary savings to ensure your financial security in your later years.
You need to be aggressive in setting your retirement goals and aim to save around 15% to 20% of income throughout your career to be prepared. That's going to require some careful budgeting, but it will be well worth it when you're financially ready for retirement even if your Social Security benefit is a little smaller than you were hoping for.
