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Tuesday, January 31, 2012

Truth about Social Security (Part I)

I'm only a decade away from drawing Social Security benefits. Since the 1970s, the Social Security program has been a hot potato in politics. It is applauded by some and excoriated by others. I have tried to make sense out of it in an FAQ format. This is the first of a two-part post.
  • Is Social Security more than just a pension for seniors? Yes, the Social Security Administration runs several programs. But colloquially, when people say "Social Security", they mean retirement benefits. I'll adhere to that custom.
  • Is it correct to say that I pay into a Social Security account so that I can withdraw from it later? No. You and your employer pay "FICA" taxes into the overall Social Security program but not into your individual account. Social Security is not an IRA or a 401(k). FICA tax receipts are fungible, and disbursements to retirees come from the pooled resources of the program.
  • Doesn't the Social Security Administration keep a record of my annual earnings? Yes, but that's merely to qualify you for a full payout.
  • Are FICA taxes regressive? Yes, in the same way that sales taxes are. There is one uniform FICA tax rate for everyone, and there are no deductions. Some people argue that FICA taxes are exceptionally regressive because there is an annual cap on the FICA tax paid by any one individual. As a consequence of this cap, people with high earned incomes pay a lower effective FICA tax rate -- measured across their entire income -- than people with low earned incomes. However, I don't consider that extra degree of regressiveness to be important; Social Security payouts to people with a history of high earned incomes are also capped.
  • Does the structure of the FICA tax have advantages? Yes, it's relatively simple to administer and to calculate.
  • Are FICA taxes payable on unearned income like capital gains? No, but it rarely matters. Most people who have substantial unearned income also have earned income that's above the annual FICA cap.
  • Is it fair to say that Social Security is of negligible significance to the wealthy? Yes. Relatively speaking, a wealthy person puts little into the Social Security program and gets little out.
  • Could I do better if I were allowed to opt out of Social Security and put equivalent money into my IRA or 401(k)? Yes, assuming the following five things are true throughout your working years: #1, your salary is above average. #2, you have the discipline to save. #3, you have disability insurance and life insurance from other sources (or are able to forego them). #4, you know enough to make prudent investments. #5, the financial markets produce decent returns on your investments. But if one or more of those doesn't hold true for you, you could do worse on your own than if you participated in Social Security.
  • Does the Social Security program have an element of income redistribution? Yes. To some extent this offsets the regressiveness of the FICA tax.
  • Is income redistribution by the government good or bad? If you answer the question in terms of your own cash flow, it depends on the math. If you approach the question from a perspective of societal good, you might answer differently. Note that we're talking about redistribution of income, not redistribution of wealth.
  • Is Social Security a Ponzi scheme? Not under the classic definition of a Ponzi scheme found in Wikipedia. However, one can legitimately question the financial soundness of Social Security without having to call it a Ponzi scheme. Stay tuned for Part II which will look specifically at the finances of the program.