For more than 80 years, Social Security has been laying down a financial foundation for our nation’s retired workforce. As of May 2020, the average retired worker was bringing home about $1,513 a month. This may not sound like a lot, but it’s enough to help pull more than 15 million retired workers out of poverty every year.
But our country’s most prized social program also bears a plain-as-day secret: It’s not fair.
Image source: Getty Images.
Social Security isn’t as “fair” of a program as you might think it is
When you think of Social Security, you’re probably thinking of everyone getting their fair share and playing their role in funding the program. The reality is, there are a number of ways the Social Security program is unfair to its recipients and working Americans.
For example, Social Security is primarily funded by the 12.4% payroll tax on earned income (i.e., wages and salary, but not investment income). This tax is applicable up to $137,700 in 2020. Since 94% of all working Americans will earn less than $137,700 in 2020, they’ll be paying into the program on every dollar they earn. Meanwhile, the well-to-do 6% who’ll earn more than the maximum taxable earnings cap will see every dollar beyond $137,700 exempted from the payroll tax. Between 1983 and 2016, the amount of earnings exempted from the payroll tax has nearly quadrupled from a little over $300 billion to about $1.2 trillion.
Another way the program isn’t exactly fair is the taxation of Social Security benefits. The Amendments of 1983 allowed the federal government to impose the federal tax rate on a portion of Social Security benefits if an individual’s modified adjusted gross income (MAGI) plus one-half of benefits exceeds $25,000 (or $32,000 for couples filing jointly). Although this isn’t an instance of double taxation, it’s viewed that way by most Social Security recipients as it’s revenue that’s predominantly collected via the payroll tax that, under the MAGI plus one-half of benefits formula, could lead to another round of federal taxation.
Image source: Getty Images.
To build on this point, 13 states also tax Social Security benefits to some varied degree. If you’re required to pay state-level taxes on a portion of your Social Security benefit — which would also mean you’re liable at the federal level — then you are subject to double taxation (i.e., the same dollar being taxed twice).
Not to continue to pick on the taxation of benefits, but it’s also worth mentioning that the income thresholds associated with this tax have never been updated to account for inflation. Thus, over time, a tax that affected about 10% of senior households in the mid-1980s now impacts about half of all senior households.
Social Security may not be fair, but that’s actually OK
However, it’s important to understand that just because the program isn’t equitable on all fronts, it doesn’t mean it’s failing in its purpose. In fact, many of Social Security’s perceived inequities make a lot of sense upon closer inspection.
For instance, let’s revisit the fact that 6% of higher-income workers aren’t hit with the payroll tax on their full annual income. This probably doesn’t seem fair on the surface. But consider this: The Social Security Administration caps the amount of monthly benefits paid at full retirement age. In 2020, this cap is $3,011 a month. The reason the earnings cap exists on the payroll tax is because the program also caps the amount of benefits an individual can receive per month.
Furthermore, when looking at aggregate taxes paid and benefits received over a worker’s lifetime, Social Security actually skews heavily in favor of lower-income workers.
Image source: Getty Images.
A 2018 update from the Urban Institute, which examined the expected present value of lifetime Social Security benefits and taxes, found that a single man with low earnings (defined as $23,400 in 2018 dollars) would pay $135,000 in lifetime taxes into Social Security (if turning 65 in 2020), but receive $193,000 in benefits. Comparatively, a maximum-earner with $127,200 in earned income would pay $710,000 in lifetime tax into the Social Security program while receiving $512,000 in benefits. The system may not appear fair on the surface, but the fact remains that those folks who need Social Security income the most during retirement are netting far more, on average, than they’ve paid into the program.
Even the taxation of benefits has some merit, despite its perception of unfairness and the reality that double taxation can happen in a quarter of all states. For example, even though more and more senior households now owe tax on some portion of their benefits, the taxation of Social Security benefits still, primarily, hits higher-income senior households the most. These upper-income households can typically afford to pay this tax since Social Security income plays little or no role in helping them make ends meet during retirement.
Furthermore, the income collected from the taxation of Social Security benefits is growing in importance and crucial to helping the Social Security program stay solvent. To be clear, Social Security isn’t going bankrupt. But in order to avoid sweeping benefit cuts in the future, additional revenue sources may be needed. The taxation of benefits is expected to generate almost $651 billion in revenue for Social Security over the next decade. The tax is hated and perceived to be unfair, but it’s helping to ensure the financial well-being of current and future generations of beneficiaries.
Ultimately, Social Security is a social investment in our nation’s elderly workers, long-term disabled, and the survivors left behind by deceased workers. Despite perceived inequities, it’s actually doing its job quite well.
The $16,728 Social Security bonus most retirees completely overlook
If you’re like most Americans, you’re a few years (or more) behind on your retirement savings. But a handful of little-known “Social Security secrets” could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more… each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we’re all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.