How Social Security works: Nuts and bolts of the benefits program
February 25, 2016
How Social Security works
1 of 6
FPG/Archive Photos/Getty Images
In 1935, in the midst of the Great Depression, President Franklin D. Roosevelt signed the Social Security Act, creating an insurance program to protect American workers from dire poverty in old age. It has since become a significant thread in the fabric of the national economy. In 2015, more than 59 million Americans — or about 18.3% of the population — received close to $870 billion in Social Security benefits.
Over time, amendments to that original act expanded Social Security to include benefits for disabled workers as well as dependents and survivors of the insured. Later, in 1965, Medicare health insurance for older Americans was added to the package.
In spite of these changes, however, the way Social Security works has remained fundamentally consistent throughout its history.
Read on to learn about the nuts and bolts of how Social Security works.
1 of 6
Where does the money for Social Security come from?
2 of 6
Atanas Bezov/E+/Getty Images
The funds tapped for Social Security benefits come from 3 sources. These are:
Interest on 2 trust funds (one for Old-Age and Survivors Insurance, the other for Disability Insurance);
Income taxes from Social Security recipients whose incomes exceed a certain threshold.
The lion’s share — about 85% — is drawn from payroll taxes.
In any given year, these taxes were originally calculated to cover prevailing needs, but in 1983, Congress raised them in anticipation of a considerable rise in expenditures once the baby boomer generation reached retirement.
Currently, 6.2% of earnings are deducted from an employee’s paycheck for Old Age, Survivors and Disability Insurance, up to the maximum taxable income for this purpose of $118,500. Everyone, regardless of income, is assessed an additional 1.45% to cover Medicare insurance. Employers must match the amounts deducted.
2 of 6
How does the government use these payroll taxes?
3 of 6
Swell Media/UpperCut Images/Getty Images
The money earmarked for Social Security cannot be used to cover other government expenses until all Social Security expenses have been met, according to the U.S. Government Accountability Office. However, whenever Social Security taxes exceed the amount needed to meet expenditures, the surplus goes into the U.S. Treasury’s General Fund, where it is used to reduce the overall federal deficit.
The money is exchanged for special issue, non-tradable Treasury bonds, with the interest from the bonds accruing to the 2 trust funds. The bonds are redeemable whenever Social Security revenues fall short of expenditures.
This practice gives rise to the common perception that the government raids Social Security to fund other programs. But according to the U.S. Treasury, it’s in line with the government’s unified budget concept, which allows the flow of funds from one program to be applied to another as needed. Without that measure, it’s argued that Congress would have to raise taxes, cut payout amounts or borrow from the public.
3 of 6
Does everybody have to pay FICA taxes?
4 of 6
MAVROUDAKIS FOTIS PHOTOGRAPHY/Moment/Getty Images
Nearly everyone working in the U.S. must pay Social Security and Medicare taxes, though there are a few exceptions.
These include federal employees hired before 1984, although since 1983 they have had to pay the Medicare portion and are therefore eligible for hospital insurance. Other groups exempted from payroll taxes are railroad employees with more than 10 years of service, employees of those state and local governments who choose not to participate in Social Security, and children under the age of 21 who are paid by a parent for doing household chores. Children over 18 years of age who work in a family business are not exempt from Social Security payroll taxes.
Some wage earners who are eligible for Social Security need to follow special rules in order to be compliant — for example, the self-employed, military personnel, domestic workers, farm workers and people who work for a church or church-controlled organization that does not pay Social Security taxes.
4 of 6
Is everyone who pays FICA taxes eligible for benefits?
5 of 6
Monty Rakusen/Cultura/Getty Images
In general, workers must accumulate a minimum of 40 work credits — the equivalent of 10 years of paid labor — to be able to collect retirement benefits. In 2016, you must earn at least $1,260 to get 1 credit, up to a maximum of 4 credits each year.
Qualifying for disability benefits also works on a credit system, but the rules are different depending on the age of a worker when he or she becomes disabled. For example, someone whose disability began before age 24 can qualify for benefits with 6 credits earned over the previous 3 years. Someone over 62, however, must earn 40 credits, at least 20 of them in the 10 years before becoming disabled.
5 of 6
What is COLA and how is it calculated?
6 of 6
COLA is an acronym for the Social Security Administration’s cost-of-living adjustment. For many years, the payments were static. Then in 1950, Congress approved an increase for the first time, and for the next 25 years, raises required an act of Congress. In 1975, annual adjustments became automatic. They’re based on the percentage increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers as computed by the federal Bureau of Labor Statistics.
In 2010, 2011 and again this year, there was no cost-of-living adjustment, since there was no increase in the consumer price index used to determine automatic annual hikes. Monthly Social Security benefits remained stagnant.
Proposals currently under consideration suggest tying Social Security’s COLA to other measures of inflation. One idea is to use the Bureau of Labor Statistics’ Chained CPI for All Urban Consumers. Proponents say it’s a more accurate measure of consumer behavior when prices fluctuate. This would likely result in lower COLAs.
Some proposals advocate using other measures of inflation based on the purchasing patterns of the elderly. Since older people are more vulnerable to fluctuations in health care costs, which go up more rapidly than other consumer goods, this would tend to increase monthly Social Security benefits.