By Akemi Kondo Dalvi, CPA/PFS™, CFP®
Most of us heard that under the current financial projections, if no changes are made, the Social Security and Medicare programs will run out of funding by approximately 2035. The exact date varies based on economic growth year over year. But relatively speaking, decisions need to be made now on how to keep these programs funded, or dissolve the programs for future generations.
Although the news headlines state that Social Security will run out by 2035, that doesn’t actually mean seniors collecting would go from receiving a monthly benefit check to zero dollars. In actuality, the estimate is that if no changes are made, the Social Security Administration (SSA) would reduce benefits to approximately 83% of the current benefits being paid, starting in 2035.
That is because the Social Security benefits program currently receives funding from two sources. The first 80% of the Social Security Income (SSI) benefits paid are collected from working Americans through their Federal Insurance Contributions Act (FICA) paycheck withholdings. The gap between the FICA taxes collected and the Social Security benefits paid is closed by the Social Security trust fund.
If no legislative action is taken, the trust fund is estimated to be depleted by 2035, leaving SSI recipients solely dependent upon FICA tax collection.
However, this solution of letting the Social Security trust fund deplete itself is unpopular and therefore unlikely. Social Security is one of the most universally supported programs across income levels, geographic regions, and political affiliations. Therefore it would do any politician well to ensure Social Security continues for the voting public who have paid into the program.
The question then is: What solutions will be implemented to keep the program alive?
One proposal is to raise the Full Retirement Age (FRA) from 67 to 68. The FRA is the age at which a person is eligible to collect 100% of their Social Security retirement benefits. The FRA depends on your birth year, and gradually increases a few months each year.
The SSA has been slowing, increasing the FRA as life expectancy increases. That is why your FRA might be different than someone older or younger than you. The current FRA for people born in 1960 or later is age 67. You can collect Social Security Income as early as age 62, but you would be penalized with a lower benefit amount.
If Congress chooses to increase FRA from age 67 to age 68 immediately, and then bumps up the FRA progressively by two months for each year of birth thereafter, that adjustment could fill approximately 44% of the current SSA funding gap. By raising the FRA, future benefit recipients would likely receive about a 13% reduction of lifetime benefits.
Another proposal to keep the SSA trust fund fully financed would be to lower the Cost of Living Adjustment (COLA) afforded to Social Security Income recipients. Currently, Social Security benefits are adjusted upwards annually to keep up with inflation. COLA was implemented in 1975 after America’s cost of living increased rapidly due to the removal of the dollar from the gold standard, rising oil prices, and supply shocks.i
The annual COLA increase is based on the Consumer Price Index for Urban Wage Earners and Clerical Workers, known as CPI-W, and calculated by the Bureau of Labor Statistics (BLS), which is a part of the U.S. Department of Labor. In 2023, the SSA increased SSI benefits by 8.7% due to rising inflation in the U.S. This was the largest COLA adjustment seen in 41 years.ii
Lowering the COLA increases to a different, less generous metric could possibly fill an estimated 23% of the Social Security trust fund deficit. However, this is considered a less likely solution as it would be politically unfavorable, and many recipients already feel that the Social Security COLA adjustments don’t keep up with inflation adequately.
Retirees note that annual COLA increases are essentially eaten up by Medicare premium increases, leaving them in a net position the same as the prior year, even though the cost of gas and groceries has gone up substantially.
Another proposal is to change the tax cap on the Federal Insurance Contributions Act or FICA payroll taxes. FICA taxes fund Social Security and Medicare benefits. In total, FICA taxes amount to 15.3% of American workers’ wages. The first 12.4% tax on earned income is paid into Social Security, up to an annual limit. In 2024, the wage base limit is $168,600.
That means a W2 employed person would pay 6.2% FICA tax, and their employer would pay 6.2% FICA tax, to sum the 12.4% payroll tax on the employee’s first $168,600 of wages earned annually.iii Any wages earned in excess of the limit would not be subject to FICA tax. In addition to the 12.4% Social Security tax, another 2.9% FICA tax is levied for Medicare benefits.
However, there is no income cap on the Medicare portion of the tax, so it would be assessed on income above the $168,600 threshold noted above. Further, there is an additional Medicare tax that high-income individuals pay in addition to the 2.9%, as of Jan. 1, 2013.
The proposal to change the tax cap on the FICA payroll taxes from the current $168,600 to a higher dollar threshold would directly reduce the Social Security trust fund gap. If the tax cap was removed altogether, subjecting all earned income to Social Security taxes, it is estimated that would fill 86% of the funding gap, but that would be an extreme measure.
Alternatively, there is a proposal to raise the 6.2% payroll tax (12.4% when combining the employee + employer tax), to a rate of 7.2%, and then leave the FICA payroll tax cap as-is, subject to annual inflation indexing. The latter proposal is estimated to reduce the Social Security trust fund gap by 64%.iv
Other proposals include reducing Social Security and Medicare benefits for the highest-earning 25% of Americans, but the financial benefits would only result in an estimated 7% reduction in the Social Security trust fund deficit.
Another proposal would be to require all newly hired state and local government workers to contribute to FICA – as many currently do not pay FICA taxes in favor of a separate retirement arrangement. The inclusion of government employees is anticipated to close 8% of the funding gap.
Finally, there is a proposal to implement a calculator that reduces Social Security Income benefits (albeit earned during employment through FICA contributions) for those earning higher income in retirement, as measured through their annual tax filing.v
No one knows exactly which of the many proposals will be adopted to revive the underfunded Social Security trust fund. Likely it will be a combination of several proposals, implemented in phases. If control of the House and Senate remains split between Democrats and Republicans after the November election, then theoretically any legislative changes will be middle-of-the-road, as both parties will need to approve the bill for passage.
However, expedient bill passage and effective communication has been absent on the Hill as of late, so it may be some time before we know what path we will trek ahead.
https://www.investopedia.com/ask/answers/081715/are-social-security-benefits-adjusted-inflation.asp
https://www.investopedia.com/2023-social-security-cola-highest-since-1981-6749572
https://smartasset.com/taxes/all-about-the-fica-tax
Bob Veres Insider Information
https://www.cnbc.com/select/will-social-security-run-out-heres-what-you-need-to-know/
The opinions expressed above are solely those of Kondo Wealth Advisors, Inc. (626-449-7783, info@kondowealthadvisors.com), a Registered Investment Advisor in the state of California. Neither Kondo Wealth Advisors, Inc. nor its representatives provide legal, tax or accounting advice.