Editor's note: An editing error in a previous version of this article changed the amount that the Social Security tax would rise under a new proposal. The correct figure is 0.05% per year, rather than 0.5% per year, beginning in 2018. The Fool regrets the error.
For nearly eight decades Social Security has been providing a financial backstop for retired American workers, for workers who have become disabled, and for surviving beneficiaries of deceased workers. Unfortunately, the Social Security program is not sustainable in its current form.
Social Security's slippery slope
Within the last couple of years, baby boomers have begun to retire in increasing numbers, which is dramatically boosting the number of retirees claiming Social Security benefits. On the other side of the equation, there just aren't enough workers to replace these baby boomers in the workforce. The worker-to-beneficiary ratio is projected to fall as low as two-to-one by 2035. The net result will be diminished Social Security tax revenue, with the Social Security Trust Fund expected to burn through its remaining reserves by 2033.
Making matters more difficult is the fact that we're living longer into our golden years. A more educated population with better access to healthier foods and medicines could means years of extra withdrawals from Social Security.
Of course, Social Security won't be bankrupt, either. The tax revenue generated by the remaining workers would be enough to sustain payouts at 75% of their current amount through 2087.That's certainly one way of ensuring retirees and qualified disabled or surviving beneficiaries wind up with some form of income. However, pre-retirees aren't too keen on the idea of receiving only 75% of what they had previously have been entitled to.
Social Security needs change if it's going to survive over the long run and continue to pay out anything near what eligible beneficiaries now receive. Fortunately, it seems Congress may be willing to take up the daunting task of a Social Security overhaul.
Three major changes Congress wants to make to Social Security
In late July, Connecticut Rep. John Larson introduced a bill into Congress known as the Social Security 2100 Act, which offered up close to a dozen sweeping reforms designed to extend the life of the Social Security Trust Fund and possibly even improve benefits for current and future generations.
Although you can certainly read through the entire bill to get a feel for the changes proposed, there are three changes in particular that could have a sizable and lasting impact on the Social Security program.
No.1: Adjust the cost-of-living adjustment
First, section 102 of the proposed bill calls for a new metric to be used to compute annual inflation, which is commonly referred to as the cost-of-living adjustment, or COLA. As Social Security stands now, the annual COLA is determined by the movement in the Consumer Price Index as reported by the Bureau of Labor Statistics. In general, if the price of a basket of goods rises by 2% in a given year, then Social Security benefits will rise by a complementary amount. This helps protect beneficiaries from having their benefits eroded by inflation.
The problem with the current method is that it takes into account all goods purchased by the entire population. Social Security, on the other hand, predominantly benefits the elderly. Therefore, Larson proposes that the COLA be calculated using another BLS statistic known as the Consumer Price Index for Elderly Consumers. Tying the COLA to the goods that matter to retirees would all but ensure that inflation wouldn't erode monthly benefits.
No. 2: Boost Social Security payroll taxes
In order to generate enough tax revenue to pay out more than $850 billion in Social Security benefits each year, employers and employees are each responsible for paying a 6.2% payroll tax on income up to a maximum of $117,000 (as of 2014). Combined, this works out to a 12.4% tax.
Under the proposed Social Security 2100 Act, beginning in 2018 and running through 2037, the Social Security tax would rise by 0.05% per year. In other words, the tax rate for employers and employees would increase from 6.2% in 2017 to 7.2% by 2037. This increase should help offset the tax revenue lost to retiring baby boomers while minimizing the shock of a temporary tax hike for existing workers and businesses.
No. 3: Increase the tax on the highest-earning individuals
Finally, the Social Security 2100 Act aims to put wealthy Americans on a similar tax footing to John and Jane Q. Public. Under the new proposal, wages in excess of $400,000 would be subject to a reduced payroll tax of 2%. This represents an attempt to get Americans to pay a more nearly equal percentage of their income into the program.
Will this work?
Could Rep. Larson's proposal work? It's certainly possible, considering that taxes will probably have to go up in order to keep Social Security solvent for decades to come without making substantial benefit cuts. However, a lot will depend on whether the incoming Congress can work together to effect meaningful change.
What this means for you is that you can't rely solely on Social Security for income in your golden years. There are no guarantees that Congress will come together to enact change in time to help you or future generations retire in comfort and security.
Ultimately, it means you need to think about ways to generate additional retirement income now. The best vehicles for retirement savings are tax-advantaged retirement accounts and long-term-focused investment portfolios. The pathway to retirement is a bit different for everyone, but diversifying your income streams is a smart move regardless of your age or financial situation.