The need for financial security as we age and become unable to support ourselves through gainful employment is not a new concept. As early as the turn of the 17th century, Poor Laws were adopted in England to provide some measure of relief to citizens unable to support themselves due to old age, disease, and so on. The concept followed colonists to America, where local taxes helped to support the destitute. Even earlier, ancient Greeks stockpiled long-lasting olive oil as a precaution for times of need.
By the time the Great Depression struck, the country had already suffered two other major economically depressive eras (in the 1840s and the 1890s), each time with increasing calls for some form of government remedy, such as unemployment insurance. The widespread devastation of the Great Depression would become the lynch pin that ultimately led to the creation of Social Security in America. How did Social Security tax start, how has it evolved, and how can you navigate the system today?
What is Social Security Tax?
The Social Security Act was signed into law in 1935, ostensibly as a response to the Great Depression and the poverty that overtook much of the country’s elderly population. In 1937, people began paying Social Security tax, which is a simple withholding tax based on earnings, and the program started paying out benefits in 1942.
The historic shift spurred by the industrial revolution created larger urban populations, but a lack of pension plans left elderly Americans with few resources once they could no longer work. Once the Great Depression hit, plenty of Americans were out of work, especially the elderly.
When Social Security began, employees were required to devote just 1% of their earnings to paying into the program. By 1960, employee contributions had risen to 3%, and by 1978, they were up to 5%. Required contributions held steady at about 6.2% from 1990 on, until the Great Recession hit and they were reduced for a time to 4.2% for employees (while employers still had to pay the full amount). Economic recovery has seen contributions return to the 6.2% mark for both employees and employers.
What Do You Get for Your Money?
Social security benefits are designed to kick in at the age of retirement. Originally, this was restricted to persons age 65 or older, but over time, the Old Age, Survivors and Disability Insurance program (OASDI), which was part of the Social Security Act, allowed for payments to persons as young as 62.
Social Security benefits are essentially meant to be a fallback for older Americans who are retired or no longer able to work due to disability, illness, and so on. The program is intended as a supplemental insurance policy of sorts for elderly citizens who can no longer work and bring in consistent income, although for some who have been unable to sock money away in a 401K or other retirement accounts, it ends up serving as a primary source of income after retirement.
In essence, those who pay in throughout the course of a lifetime of work can collect benefits down the road, upon retirement, as long as certain criteria are met (such as paying in for a minimum of 10 years before retirement or disability that prevents working, for example). When a worker eligible for Social Security benefits dies, a surviving spouse and/or eligible children may receive payments in their stead.
How Does Social Security Tax Work?
Social Security tax is tied in with tax contributions for Medicare, jointly referred to as the Federal Insurance Contributions Act, or FICA. According to IRS Publication 15, federal employment taxes apply to all pay given for services performed, and it states, “The pay may be cash or in other forms. It includes salaries, vacation allowances, bonuses, commissions, and fringe benefits.” This could include lodgings, food, and more, unless explicitly excluded (such as lodgings for household or agricultural workers, for example).
An employee’s Social Security contributions are based on pre-tax earnings, so even if you contribute pre-tax dollars to a 401K, you’ll still owe Social Security tax for those earnings. Of course, there is a cap in place to ensure that employees don’t pay more in taxation han they can receive in benefits later on.
As of 2018, the cap for annual earnings eligible for taxation under OASDI was set at $128,400, meaning that the maximum amount that can be withdrawn from income to be put toward Social Security tax is set at $7,960.80. It bears mentioning that no such cap exists on Medicare tax, which is withdrawn from employee pay at a rate of 1.45%.
For self-employed workers who do not have an employer contributing to FICA, the tax is doubled, as they must pay both the employee and employer contributions. This means they must make Social Security contributions of 12.4% and Medicare contributions of 2.9% of annual income.
Paying Taxes on Social Security Benefits
Unfortunately, paying into Social Security doesn’t necessarily exempt you from paying taxes on benefits you receive after retirement. Unless you’re living on Social Security income alone, there’s a chance you’ll be on the hook to pay taxes on the money you receive from Social Security benefits each month.
Taxation of your Social Security benefits will depend largely on your earnings. Right off the bat, you should know that no more than 85% of the money you receive in Social Security benefits is eligible for taxation, regardless of total income.
The amount you owe in taxes will depend on your combined income, which includes half of your Social Security benefit, along with your adjusted gross income and nontaxable interest. In other words, you’ll have to decide if the income you earn from working is considerably more beneficial than the taxes you’ll owe for collecting Social Security benefits while continuing to work.
Social Security is a complex system, and it can be difficult to determine how to gain the best benefits in the long run. With assistance from expert financial advisors, you have the best opportunity to save for your future and avoid undue taxation after the age of retirement. Contact the qualified professionals at Dechtman Wealth Management today at 303-741-9772 or online to schedule a complimentary consultation and learn more about your options.