What Is Social Security and How Does It Really Work?

Social Security cards and assorted cash.
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Most Americans have at least heard of Social Security, but many don’t fully understand how it works and what it does. Some believe that Social Security provides a lifetime of income replacement for seniors in retirement, while others believe that it won’t exist at all in just a few short years.

Neither of these two extremes is accurate, but they both share some level of truth. How can that be? Read on to learn what Social Security is, how it works, and what is in store for it in the future — with a particular focus on Social Security retirement benefits.

How Social Security Is Funded

Social Security is primarily funded with payroll taxes on American workers. You may have noticed a deduction on your pay stub for “OASDI,” which stands for Old-Age, Survivors and Disability Insurance.

These are the taxes that fund Social Security. The “OAS” portion of your Social Security taxes amounts to 5.3%, and the “DI” portion is another 0.90%, for a total of 6.2%. These taxes mainly fund the retirement portion of Social Security, but also benefits for survivors and the disabled.

You may also notice a deduction for Medicare taxes in the amount of 1.45%. While Medicare taxes aren’t technically for Social Security, they are often lumped together in the discussion. Employers must pay an equivalent amount of taxes on behalf of their employees, meaning both employees and employers contribute 6.2% in Social Security taxes and 1.45% in Medicare taxes, for a total of 7.65% each.

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Self-employed individuals, as they are considered both employers and employees, must contribute the full tax amount, or 15.3%.

Requirements for Eligibility

To qualify for Social Security retirement benefits, you must have earned at least 40 “quarters of coverage.” Essentially, this requires at least 10 years of employment during which you paid Social Security taxes.

For 2022, you’ll earn one quarter of coverage as soon as you have earned $1,510. Eligibility for other Social Security benefits, such as survivors benefits and disability payouts, aren’t based on your work record. You may qualify for a survivors benefit if your spouse (or in some cases, your ex-spouse) was entitled to benefits, while a disability payout requires total and complete disability for at least one year.

How Benefits Are Calculated

Social Security retirement benefits are calculated primarily based on your earnings record throughout your work career. Once you have 40 quarters of coverage and qualify for benefits, the Social Security Administration will calculate your benefit using a complex formula. Your estimated benefits can be found at any time if you create an account on the Social Security Administration website.

As of January 2022, the average retirement benefit was $1,655 per month, while the maximum possible benefit was $4,194.

Collecting Social Security Early

Another factor in determining the size of your Social Security retirement benefit is when you claim it. Although full retirement age for those born after 1943 is 67, the Social Security Administration allows you to file for retirement benefits as early as age 62. However, your monthly benefits will be reduced by as much as 30% for the rest of your life.

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Of course, you’ll also receive 60 more monthly payments than you would if you waited until age 67. To determine whether or not this makes financial sense for you, you should speak with a tax or financial advisor who understands your complete financial situation.

Collecting Social Security Late

Just as you can file for Social Security early, you can also delay payments until as late as age 70. In so doing, your monthly benefits increase by 8% for each year after 67 that you wait. For those who either don’t need the money at age 62 (or 67), or who anticipate living a long life, collecting Social Security late can result in a significant boost in lifetime payments.

However, the opposite may be true for those in need of funds as soon as possible, or who don’t anticipate living a long life. As with claiming Social Security early, it pays to discuss these options with a seasoned tax specialist and/or financial advisor.

Is Social Security Going Away?

There has been much discussion in recent years about how Social Security is “going away,” and that current workers shouldn’t count on receiving anything by the time they retire. This is a misleading concept, and essentially is outright false.

It is true that the Social Security trustees have reported that the Social Security Trust Fund will be depleted by 2034. However, the vast majority of Social Security payouts come from taxes on current workers, not on any reserve fund. The Trustees estimate that unless something is done, retirees in 2034 will only receive about 78% of their current estimated benefits.

However, as Social Security is such a political football, it’s likely that some sort of accommodation will be reached over the next decade to keep the Trust Fund solvent. Some proposals that have already been tossed around include expanding the Social Security taxable wage base, increasing the full retirement age or raising the Social Security tax rate.

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