If you're getting ready to retire, you likely have a lot of questions about the best time to claim Social Security. If you're among the younger generation (Millennials/GenX), your main question might be – when will Social Security run out of money?

Both of these are legitimate questions. It's probably safe to say that even those ready to begin taking their benefit might be asking when Social Security will run out of money too.

In this post, I'll give you the facts about the state of the Social Security trust fund, and introduce you to some of the ideas to fix it. We'll talk about how all of this impacts the decision of when to claim your benefits.

How Social Security Works

The method for calculating Social Security retirement benefits is not simple. Let's take a look at the three-step process to calculate your benefit.

Step 1 – Determine the highest 35 years of income

At age 62, Social Security (SSA) determines your highest 35 years of earnings (indexed for inflation). If you left the workforce for an extended period, your work record would show years where you earned no income.

That is often the case with stay-at-home moms who leave the workforce to raise their children. After the kids are out of school, they often want to go back to work.

However, the gap in the non-working years (which could total 18 years or more) results in several years of zero income. If she has 35 years or less of working years, those years of zero income will be included as part of the calculation. You should always check your earnings record for accuracy.

Step 2 – Determine the average indexed monthly earnings (AIME)

SSA uses the AIME as the basis to calculate your primary insurance amount (PIA). The PIA is the amount you will receive when you reach your full retirement age (FRA). For baby boomers born between 1943 and 1954, your FRA is age 66. If you were born after January 1, 1955, two months is added to your FRA for each succeeding year. Anyone born after 1960 has an FRA of age 67.

SSA sets a maximum taxable earnings amount each year. You pay no SS taxes for income over the maximum. For 2018, that number is $128,400.

When SSA gets the 35-year total income, they divide that total by 420 (35 years X 12 months = 420). That number is your AIME.

They then apply a formula using something called bend points (explained below) to calculate your PIA. Social Security is a progressive system. As such, SSA credits a higher percentage of lower incomes when calculating the PIA.

Step 3 – Calculate the primary insurance amount (PIA)

The best way to illustrate this is by example:

  • Baby Boomer born in 1956
  • Maximum Social Security earnings every year since age 22
  • AIME = $9,937
  • PIA formula:
    • $895 (first bend point) x .90 = $805.50
    • $4,502 x .32 = $1,440.64 ($5,397 (the second bend point) – $895 (first bend point) = $4,502)
    • $4,540 x .15 =    $680.95 ($9,937 – $5,397 (second bend point)= $4,540)
    • Total = $2,927.09

PIA = $2,927.00 (Amount worker will receive at full retirement age)

* Example courtesy of Elaine Floyd, CFP, Horsesmouth

You can clearly see the highest percentage credit of the bend points (90%) goes to the lowest levels of income. The crediting percentage goes down for the next two bend points. The total of the three calculations is your PIA.

Social Security is one of the few inflation-protected sources of retirement income. Here's how the cost of living adjustments (COLAs) work.

COLA calculation

The Social Security COLA is calculated based on the Consumer Price Index (CPI-W). They measure the increase from the third quarter of the past year to the third quarter of the current year. There is much discussion on whether the CPI-W is the correct measure to use in the calculation. According to the Bureau of Labor Statistics‘  (the agency responsible) website, the CPI-W index is meant to “track retail prices as they affect urban hourly wage earners and clerical workers.” The CPI-W covers around 37% of the workforce.

The CPI-U, on the other hand, is “a more general index. It seeks to track retail prices as they affect all urban consumers.CPI-U encompasses about 87 percent of the United States' population. One of the major criticisms of the CPI-W index used is that it dramatically underestimates healthcare costs. For senior citizens, healthcare represents a much more significant percentage of expenses. Follow this link to the Social Security Administration page on the cost of living adjustments.

2019 changes

COLAs

In 2019, the COLA for those receiving Social Security was 2.8%. The 20108 COLA was 2.0%. That's the most substantial increase since 2011 when it was 3.6%. Below is a chart showing how the 2019 COLAs affect the average income for Social Security recipients:

COLAs comparison

Of course, higher salaries receive a higher increase. A benefit increase of $39 may not seem like much. Keep this in mind. From 2012 to 2016, the average COLA was 1.04%. In 2015 there was no increase. In 2016 the increase was 0.3%. The 2.8% COLA represents the average SSA uses to project how inflation impacts benefits in the long-term.

Taxes

Employers and employees share in the taxes paid into Social Security. The tax rates remain the same in 2019 at 7.65%. As an employee, that's the amount withheld from your paycheck. It's also the amount paid by your employer. The total tax paid by both is 15.30%.

If self-employed, you are paying the 15.30% in total; half as an employer, half as an employee (assuming you take a salary).

However, the 7.65% that's split includes the Medicare tax. The Social Security portion is 6.20%, while Medicare is 1.45%. SSA limits the Social Security tax to a maximum income level. In 2018, you paid that tax on the first $128,400 of income. For 2019, that amount goes up to $132,900.

The 1.45% Medicare tax does not have an income limit. In other words, you pay that tax on every dollar you make.

When debating what to do to shore up Social Security, one of the things always discussed is to raise or eliminate the income maximum for Social Security taxes.

Earnings test

For those who claimed their benefits before full retirement age (FRA), and still working, here are the changes in income allowed. SSA calls this the earnings test.

For 2018, you could make $17,040. In 2019, it's $17,640. Again, that's for those claiming benefits before FRA (which is age 66 to 67 depending on DOB). The consequence for earning over those amounts is that SSA withholds $1 out from benefits for every $2 you earn above $17,640.

Once you reach FRA,  the income allowed is $46,920 in 2019, up from $45,360 in 2018. That breaks down to $3,910 monthly. For the months before reaching FRA, SSA withholds $1 for every $3 in earnings above that amount.

Any benefit amounts reduced get added back once you reach your FRA. The result is a higher benefit than what shows on your MySocialSecurity account. My advice to clients is to wait until at least until you reach FRA to claim. The exception is for those in financial need. With that said, keep in mind that advice is general advice. It's always best to analyze your situation, either with an advisor or with software that helps you do the math.

I told you it was complicated.

Get the facts on the changes with the 2019 Social Security Fact Sheet.

Will Social Security Run out of Money?

Now that we have a better understanding of how Social Security works, let's tackle the main question – will Social Security run out of money. If we're talking about the trust fund, the answer is yes. The trust fund will run out of money.

Don't be alarmed by that statement. Let's dig deeper.

How the trust fund works

Before diving into the solvency of the Social Security Trust Fund, let's first get an understanding of what it is.

The Social Security Trust Fund consists of two separate funds. First is the Old-Age and Survivors Insurance Fund (OASI). The OASI is what pays our retirement and survivor benefits. It's what most of us think about when it comes to Social Security.

The second fund is the Disability Insurance Fund, which, as the name suggests, pays disability benefits to qualified beneficiaries. Payroll taxes fund both of these accounts and interest earned on the Treasury securities the fund owns. The purpose of this money is to pay benefits and administrative costs to run the two funds.

The trust fund's only investments are Treasury securities guaranteed by the “full faith and credit” of the U.S. Government. As stated on the Social Security website, “A market rate of interest is paid to the trust funds on the bonds they hold, and when those bonds reach maturity or are needed to pay benefits, the Treasury redeems them.”

Trust fund financial projections

That brings us to the solvency question – Is Social Security going broke? Asked another way, will Social Security run out of money?

Below is a comparison of the 2018 and 2019 trust fund financial reports.

SSA trust fund comparison

It's a pay as you go system

Remember, Social Security is a pay as you go system. Current retirees' benefits get paid from current workers' payroll taxes. As long as payroll taxes exceed benefit payments, the trust fund is in good shape. If that situation reverses itself, deficit spending is the result.

In 2018, the trust fund assets increased by $3.1 billion. Here's a quote from the SSA Actuarial summary page, “The Trustees now project that OASDI annual cost will exceed total income beginning in 2020—two years later than projected in last year's report—and continuing throughout the projection period. After the projected trust fund reserve depletion in 2035, continuing income would be sufficient to pay 80 percent of program cost, declining to 75 percent for 2093.”

So, it's technically correct to say that in 2035, if it continues as projected, the trust fund will run out of money. However, as with most government programs, it isn't that simple.

Here's why.

Benefits don't stop in 2035

In simple terms, the reason the trust fund runs out of money is that workers who receive benefits take more money out than current workers pay into the system. Hence, the shortfall. However, that does NOT mean the benefits stop when the fund runs out of money. Why? Remember, it's a pay as you go system. That means current workers continue to pay into the system.

According to trust fund estimates in the table above, revenues cover 80% of benefits in 2035. It covers 75% of benefits at the end of the 75 year reporting period. Is that a problem? Of course, it is. Can it be fixed? Of course, it can.

Unfortunately, many retirees start their Social Security benefits at the earliest possible date. One of the reasons given for that is the thinking there won't be money available to them if they wait. Most people haven't bothered to get an answer to the question we asked – will Social Security run out of money.

Starting early may be a costly mistake. Waiting allows your Social Security benefit to grow by as much as 8% per year between your full retirement age and age 70. Carefully analyze your options before deciding on a claiming strategy. This article contains a list of some calculators to consider.

There are many good reasons to take benefits early. Fear of funds not being there should not be one of them!

Proposals for fixing Social Security

There has been much debate and discussion over how to fix the future deficit spending in Social Security.

Here are some of what we've heard:

  1. In 2019, the government withheld FICA taxes (Social Security and Medicare) on the first $132,900 of our earned income. In 2018, that threshold was $128,700. One proposal raises the maximum taxable income even higher. Another eliminates the threshold. Either choice means more income gets taxed, increasing the amount available to pay benefits.
  2. Raising the retirement age is always on the table. Proposals range from age 67 to age 70. The result – working longer means higher tax revenue.
  3. Lowering the COLA by using a different CPI measurement. Another proposal eliminates COLAs for higher-income recipients.
  4. Reducing benefits for higher wage earners. It isn't clear what level of income that is.

These are all reasonable proposals. Time will tell which, if any, get implemented.

Final thoughts

That isn't the first time we've been in this situation. Congress has always acted before a catastrophe arrives. Even with the current congressional dysfunction, I see no reason that won't happen again. No Congressperson or Senator wants to be known as someone who voted against fixing Social Security. It would be political suicide. Being in the office is just too good of a gig to let a wrong decision on Social Security get them voted out of office.

Social Security offers a lifetime, inflation-adjusted income stream that you can't outlive. You've paid for it during your working years. There's no reason to believe you won't receive the promised benefits. Taking benefits early for fear of the funds not being available could be a costly mistake. If you need it for financial reasons, that's another story. By all means, take it.

Though there's no guarantee, I believe Congress will act to shore up the trust fund and preserve this great program. Is everyone going to be happy with the changes made? Not likely. As with any legislation, some will like it. Some will not. However, I cannot imagine a situation where Congress would eliminate a program that currently pays over 61 million people (voters) benefits.

Resources

Here are some other useful resources you should check out:
Centers for Medicare and Medicaid Services (CMS)
Medicare and You – The Official Government Handbook
Medicare.gov
Social Security Administration (SSA)
Deemed Filing

Now it's your turn. Will Congress act? What changes do you think would help? How do you think these changes will affect you?