Social Security was established in 1935, due to so many elderly people going hungry during the Great Depression. President Roosevelt felt people were losing hope. The Welfare Department was established and Social Security began. In the past, FICA tax paid into the Social Security system on a portion of income was never subject to income tax.
With that historical background, now let’s take a closer look at Social Security today and how it works 75 years later. I have researched over 50 of my clients at all ages by examining their Social Security benefits statement and this is what I’ve found: The average portion that you will have paid into FICA tax during your working life will be close to $43,000. Using the monthly income that the government promises to pay you for your lifetime, I have found on average that within two years you will have received all $43,000 back into your pocket.
Now what if you made a lot more money, thus had to pay more in FICA tax? Your benefit will be higher, of course. But you will still
have received back all that you paid within about two years. Now does your Social Security benefit stop after you receive back everything you put into the system? Of course not, and if you, me, or anyone else lives to today’s average life expectancy of 84 for men and 87 for women, you will receive over $400,000 in Social Security benefits! This could be considered the Social Security deal-of-a-lifetime: Pay in $43,000 over 30 years and get back about $400,000 over 20 years. This is the best pension deal anyone has ever had!
But, and it’s a big but, Congress never planned on this happening when it instigated the Social Security system. In the 30’s, 40’s and even 50’s, most people retired at age 65 and died five to 10 years later. But that started to change in the 1960s and today has exploded into this huge payout.
How can the government afford this? The answer of course is it can’t!! When Congress voted to cut benefits in the early 1980’s to deal with the problem of a huge payout it could not afford, citizens pushed back hard and the effort to cut Social Security was abandoned. Then someone suggested the government tax Social Security benefits to help make up the drag on the system, and thus Social Security income is now subject to tax. All retirees get their same Social Security income and since so few people actually check their tax returns, no one seemed to be pushing back on this new tax law. But with that change, retired people instantly lost 20 percent of their income without even realizing it.
With that historical perspective, let’s now look at what that means for you today using the Social Security tax rules as of 2015 using the base amount showing on your tax return as “Modified Adjusted Gross Income”:
Single: $25,000 – $34,000, then 50% of Social Security is subject to income tax. If income is greater than $34,000, then 85% of your benefits become subject to income tax.
Married Filing Jointly: $32,000 – $44,000, then 50% of Social Security income is subject to income tax. If income is greater than $44,000 then 85% of your Social Security benefits become subject to income tax.
Here is the bad part of this formula. You have to use one-half of your Social Security benefits to establish your base income for this formula. Example: A person receiving $1,800 a month from Social Security multiplied by 12 months = $21,600. Half of this, $10,800, must be included as income, which could force Social Security benefits to be taxed. A person can only earn up to $25,000 from all sources or benefits will be taxed. Retirement income from IRA or 401(k) accounts can easily exceed this amount, so when someone is so proud they saved a lot of money in their tax-deferred 401(k) plan, they just assured themselves of getting a haircut on their Social Security benefits.
Congress has deceived us, in my opinion. Hindsight says they should have just told us they will reduce benefits according to the length of life. If they would have done this in 1950, or 1960, or 1970, there would not be such a problem today. Watch out for changes, because the government can NOT keep paying out this much money to all the Baby Boomers retiring at the rate of 10,000 each and every day.
A potential solution for you is to convert any tax qualified savings accounts like IRAs, or 401(k)s, to a Roth IRA, which means you have to pay income tax when you do the conversion, but once converted, this money will never be taxed again. So it is better to convert early in your life so that the growth does not compound your income taxes and force your Social Security benefits to be subject to income tax. This effort will take planning, organization, knowing the rules and controlling your spending to have enough money to pay taxes today and not allow investments to grow tax-deferred and crush Social Security benefits at a time when you really need them the most. If you need more help, contact me: firstname.lastname@example.org.