The Social Security program -- a financial safety net primarily put into place to support low-income workers during retirement -- covers 94% of all workers in this country (167.5 million) and pays the average retiree $1,328 per month as of January 2015, according to the latest data from the Social Security Administration.
For unmarried elderly individuals, Social Security can take on special importance. Per the SSA, nearly half (47%) of all single elderly retirees count on Social Security income for 90% or more of their benefits. Optimally, Social Security is designed to replace about 40% of a workers' previous income.
Yet, for the importance that Social Security benefits can play prior to and after our retirement, the program itself is somewhat complex and confusing for the average American. To help clear up some of that confusion, let's take a closer look at three common, but complex, Social Security questions and answer them.
Question 1: Will Social Security be around when I retire?
The answer is yes, but the way Social Security looks today could be different by the time you retire.
Social Security is comprised of two trust funds: the Old Age and Survivors Insurance Trust, or OASI, and the Disability Insurance Trust, or DI. As it stands right now, the DI could exhaust its cash reserves by 2016, and the combined OASDI (i.e., OASI and DI combined) will deplete its cash reserves by 2033. This is being blamed on a demographic shift caused by baby boomers retiring and people living longer than ever, thus reducing the worker-to-beneficiary ratio. In other words, the Fund won't be bringing in enough revenue to meet its benefit payments.
However, this doesn't mean Social Security is bankrupt or heading toward insolvency. If nothing is done by Congress before 2033, though, Social Security benefits will drop by around 25%. This benefits reduction would sustain the program through 2087 before another small reduction may be needed.
There are ideas as to how to fix Social Security, either through raising taxes, cutting benefits, or some combination of the two, but Congress has been unable to come to an amicable solution on how to make up the expected money shortfall in the OASDI that will deplete its cash reserves by 2033.
Question 2: How are Social Security benefits calculated?
Your Social Security benefit is determined by adding up your 35 highest years of income and dividing that figure by 420 (35 years in months) to determine what your average indexed monthly earnings (AIME) are. I say "indexed" because the Social Security Administration factors in cost-of-living adjustments, or inflation, into your annual income. But, if you worked less than 35 years, the SSA will average in zeroes for every year shy of 35 that you worked. Thus, it's always good policy to aim for at least 35 years worked in order to keep those benefit-killing zeroes out of the equation.
Once you have your AIME, your benefit at full retirement age can be determined by the following calculation:
(90% of the first $826 of your AIME) + (32% of AIME above $826 and through $4,980) + (15% of AIME above $4,980) = your full retirement benefit per month
As a crude example, the average American salary works out to around $51,000, or $4,250 per month. If $4,250 were the AIME (assuming over 35 years), the full retirement age benefit would be $1,839 per month:
- 90% X $826 = $743.40, plus
- 32% X ($4250-$826) = $1,095.68, equals $1,839.08
There are caveats to this calculation as well. The above benefits formula from the IRS assumes your income payment at full retirement age (which is 66 at the moment). If you choose to retire at age 62, for example, and file for Social Security benefits, your benefit payment will be 25% lower than what you'd have been entitled to in the above calculation if you had waited until your full retirement age. Likewise, your payment can adjust higher than the above formula if you wait until age 70 to claim your benefits.
Question 3: Are Social Security benefits taxable?
If you make too much or live in certain states, then yes, your Social Security benefits could be taxable. Currently, about a third of Social Security recipients wind up paying some taxes on their benefits.
In order to determine tax liability for single filers, the SSA suggests you take half of your annual Social Security benefits and add them together with your adjusted gross income and nontaxable interest for the year. If that figure is less than the IRS-defined "base amount" of $25,000, your benefits won't be taxed. If you made more than $25,000 but less than $34,000 based on this rough formula, then 50% of your Social Security benefits could be taxable. If this figure is higher than $34,000, then a maximum of 85% of your Social Security benefits may be taxable.
For couples filing a joint return, the base amount shifts to anything under $32,000 combined, exempting your Social Security benefits from taxation. Note, the same formula as before applies for couples: Half of your combined social security benefits plus adjusted gross income and nontaxable interest. For couples filing a joint return earning between $32,000 and $44,000 annually, half of their Social Security benefits could be taxed. For couples making more than $44,000 annually, up to 85% of their benefits may be taxed.
On top of this rough IRS formula, 13 states tax Social Security income, although many offer some degree of exemption. But, if you live in Minnesota, North Dakota, Vermont, or West Virginia, your Social Security income is taxed without exemption.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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