Many people don't realize it, but the majority of taxpayers actually pay more in Social Security tax than they do in income tax. However, despite all of the money flowing into the system, Social Security's coffers are in danger of being depleted over the next couple of decades. Here's why Social Security taxes aren't enough, and what we can do about it.
Does the average American really pay more Social Security tax than income tax?
At first glance, it may not look like this statement is true. Social Security brought in $646.2 billion in 2014 from payroll taxes, half of which comes from workers. And, there were about 148.7 million tax returns filed, which implies that the average American household paid $2,172 in Social Security taxes. Meanwhile, the average household's income tax liability was $9,569 -- more than 4 times as much.
However, averages can be deceiving. In this case, the highest earners pay much more in income taxes than Social Security taxes, so it skews the data.
According to an analysis by the U.S. Treasury Department, all income groups besides the top 20% of earners pay significantly more in payroll taxes than income taxes, which includes all households with incomes below $77,997. In fact, this bottom 80% pays a total of $473.5 billion in payroll taxes and just $60 billion in net individual income taxes (including households with negative income tax liabilities).
So, when you consider the majority of American households, they do indeed pay more in total to Social Security than they do to the IRS.
In fairness, many of these low- and moderate-income families receive the Earned Income Tax Credit (EITC), a refundable credit which is intended at least in part to help offset the effects of payroll taxes. In the most recent tax year for which IRS data are available, almost 29 million tax returns claimed the EITC, and the average amount of this credit was $2,362 -- a total of about $68 billion.
In one sense, the EITC distorts the data I cited above, because its impact affects the income tax liability. However, when you add that $83 billion back in, payroll tax liability for all but the highest earners is still significantly higher than income taxes.
How much money is flowing into Social Security?
American workers pay 6.2% of their first $118,500 in earned income to Social Security, and their employers pay an equal amount. Self-employed individuals pay both sides of the tax, which is known as the self-employment tax.
Social Security tax is higher than income tax for most Americans because of the nature of the income tax system. Specifically, when you fill out your tax return, you get a personal exemption, standard or itemized deduction, and maybe even some tax credits. All of these can reduce your income tax, but have no such effect on your Social Security tax.
As I mentioned before, $646.2 million flowed into the Social Security system from payroll tax revenue, including the contributions from employees and their employers in 2014, the latest year for which such data is available. However, $706.8 billion flowed out of the system to pay for benefits. And, this cash-flow deficit is expected to get worse, averaging $76 billion per year through 2018.
The shortfall and what it means to you
Now, the shortfall isn't quite as bad as that last statement makes it seem -- not yet, anyways. The money in the Social Security trust funds is invested and earns interest, so another $94.8 billion flowed into the system in this form. And, another $28 billion came from taxes on Social Security benefits themselves. So, for the time being, Social Security is taking in more money than it's paying out, when you consider these other sources.
The problem is what will happen in a few years. Since much of the trust funds' investment income is being paid out in the form of benefits and isn't being reinvested, their balances aren't growing as much as they should be. And, a wave of baby boomer retirees and the general trend of the population living longer lives mean that benefits will begin to be paid out at a higher rate.
As a result, the entire Social Security program is expected to start losing money each year beginning in 2019, and the trust funds will run out entirely in 2034. After that point, the only revenue flowing into the system will be from taxes, which will only cover about three-fourths of promised benefits.
What can be done about it?
There are several potential fixes for the funding problem, most of which have to do with cutting benefits or raising taxes. Just to name some of the more popular solutions:
- The full retirement age could be increased from 67 to 68, or even 70, phased in over a number of years.
- Benefits could be cut for high-income workers, or across the board.
- The cost-of-living-adjustment method could be changed to a slower-growing index.
- Instead of basing Social Security benefits on 35 years of work, this number could be increased in order to lower the calculated average.
- The $118,500 wage cap for Social Security taxes could be increased, or eliminated entirely.
- Payroll taxes for employers and employees could be increased to 7.2% or even to 8.2%.
In addition to these, there has been some talk about possibly using money from other sources to boost Social Security's income. For example, one current presidential candidate (Donald Trump) has mentioned discontinuing sending foreign aid money to potentially hostile countries, and redirecting it to Social Security instead.
What will be done?
It's impossible to know for sure, and there is a possibility that nothing will get done (after all, we're talking about Congress here). However, history tells us that something will be done to fix the system.
Of all the potential solutions I mentioned, tax increases are the most popular among the American people across all age groups, income brackets, and political parties. It's pretty clear that Americans are willing to pay higher taxes in exchange for the peace of mind that Social Security will be funded when they're ready to retire.
On the other hand, the solutions having to do with benefit cuts, including raising the retirement age and cutting benefits for wealthy retirees, are largely unpopular. And, in my opinion, they are unlikely to gain any real political traction.
It's also important to note that research shows that none of these solutions are expected to be enough to fix the problem all by themselves. Therefore, the most likely fix will be a combination of things, and will depend on a lot of factors -- such as who's the president, what party is in control of Congress, and whether or not the projected severity of the funding gap changes over time. However, Americans should rest comfortably knowing that the vast majority of politicians want to save Social Security, so it's a question of "when," rather than "if."
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.