How Social Security Works

Social Security Old Age and Survivors Insurance is a program which every American who makes wages pays into every year of their life. Social Security takes 12.4% out of every paycheck in the country, for the pinky promise that you will receive some benefits when you retire.

There are a lot of myths on how Social Security, works, so let’s break down the biggest myths one by one.

Your employer does not pay half

This is a complete lie which most financial advisors will tell you. When studying tax policy, one of the first things you will learn is how a tax wedge works.

Supply and Demand

This graph shows what happens with any tax, not just Social Security.

  • P stands for Price
    • PS is the price the Supplier will pay
    • PC is the price the Consumer will pay
    • PE is the price there would have been if no tax had been levied.
  • Q stands for Quantity
    • QE is the quantity which would have been traded if no tax had been levied.
    • QT is the quantity which was sold because of the tax
  • T stands for Tax
    • TS is the tax paid by the supplier
    • TC is the tax paid by the consumer
  • DWL stands for deadweight loss, which is the lost economic welfare due to the tax.

From this we can learn several important lessons:

  1. The tax paid by the supplier and the tax paid by the consumer will never be the same.
  2. Every tax will reduce the quantity demanded of the good or service being taxed.
  3. Both supplier and consumer is in effect paying the tax, no matter who writes the check to the government.

In the case of labor, the worker is the supplier and the employer is the consumer. An easy way to remember this is that in any transaction the supplier will be paid, and the consumer will pay.

Calculus teaches us that when we have a function with a limit which approaches a value it will never actually hit that value, just like that mythical supply and demand graph where their slopes are the inverse of each other.

This is why the claim that employers pay half of Social Security taxes is a complete lie and because of Calculus it literally never happens.

My taxes do not go to my benefits

This is also not how social security works. The system is somewhat byzantine, and the easiest way to explain it is to explain how an IRA works as a baseline, because it is a much simpler system.

In an IRA, you invest money into an investment plan. This will most likely be a mixture of stocks and bonds, which will likely grow because of interest until you retire. That money is legally yours, and when you retire you will withdraw an amount which will ideally not touch the principal, leaving inheritance for your children. IRAs are generally tax deferred, which means you can earn interest on money which otherwise would have been taxed, but the tradeoff is that when you withdraw the entire amount is taxed with special rules. But, the most important thing to understand is that every dollar you put into your IRA counts. Any money left over will be distributed according to your will, or if you don’t have a will by your State’s inheritance laws, which is generally your spouse and then your children.

Social Security is a much more complicated system. It is fully explained in this government document.

  1. Calculate the number of computation years.
    1. Generally 35. Can be changed by Congress.
  2. Wage Indexing of Earnings
    1. Basically calculates the inflation of the average annual wage from the year that person worked versus the index year which is two years before today’s date.
    2. Multiply that number by that person’s wages of each year, unless if they made more than the maximum creditable, in which case you multiply by that number which changes annually.
  3. Computing the Average Indexed Monthly Earnings
    1. The highest 35 years of indexed earnings are used to calculate your benefit. This is divided by 420 months.
  4. Computing the Primary Insurance Amount
    1. for the first $700 of AIME (in 2019) multiply by 0.9
    2. Multiply all money made between $700 and $1500 AIME by 0.32
    3. Multiply all money made between $1500 and $6000 by 0.15
    4. These bend points only apply to people born in 1957. For everyone else, their bend points are different.
  5. Computation of Monthly Benefit
    1. Add up the three values calculated in step 4.
  6. Early or Delayed Retirement Benefit changes
    1. Multiply the number calculated by Step 5 by the number required for early or delayed retirement.

Congratulations, you now know how to calculate your OASI Benefit! (assuming you don’t have spousal benefits as well)

By this calculation, here are some examples, for people who retired on their 62nd birthday in 2019:

  • $25000 per year:
    • $727 per month
    • 34% of salary
  • $50,000 per year
    • $1051 per month
    • 25% of salary
  • $100,000 per year
    • $1699 per month
    • 20% of salary

Source: Benefit Calculator
It can be very confusing for those who are new to it. All of these seemingly arbitrary numbers can also be changed by Congress at any time, in any direction, for any reason.

My taxes go to my grandparents

Your taxes do not go into some fund to save for your retirement. That’s how an IRA works. Your taxes go to pay for this year’s retirement and any money left over then is borrowed by the Federal government to pay for other programs. Nothing is actually saved for you. That’s how it works in Singapore and Australia.

The purpose of publishing this now is so people will understand how Social Security works since Donald Trump is talking about it in the news a lot right now.

 

Also, you still have to pay your Social Security taxes in April.

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