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Source: Flickr user DonkeyHotey.
According to their 2014 Trustees Report, the Trust Funds that support Social Security are expected to run out of cash around 2033. If that happens, Social Security will be unable to make payments that are both timely and complete.
Despite those problems, if the worst comes to pass, Social Security would not stop sending out benefit checks. Instead, it would be forced into one of two options: providing full payments on a delayed schedule or partial payments on its regular monthly schedule.
Why is this happening?
Social Security is prohibited from paying out more than it can cover from the funds available to it -- essentially a combination of the payroll taxes it collects and its trust fund. Thanks to an aging population,declining workforce participation,rising disability claims, and poor investment returns, Social Security's Trust Funds simply won't be filled fast enough to cover all future expected claims.
There's approximately $2.8 trillionin those Trust Funds today. That may seem like a lot of money, but when it runs out, the cuts will be both swift and significant. The chart below shows how Social Security expects to cut benefits by 23% once its trust funds are emptied:
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Source: Social Security, 2014 Trustee Report.
What can you do about it?
As you consider your options for how to deal with this shortfall, the first thing you should understand is that one way or another, you will be the one paying to cover the gap. This isn't some far-off event that might happen to someone else; this is the reality, and even some current retirees will be affected by Social Security's funding shortfall.
One way or another, the American people will have to pay to keep Social Security running:
- If nothing happens, you will cover the gap through lower future benefits.
- If Congress once again patches Social Security as it has in the past, you will cover the gap through higher taxes or lower benefits (or, most likely, some combination of both).
- If you invest to cover the gap, you will put your money at risk and defer your ability to spend in order to build a portfolio capable of covering your needs later.
Of those three options, investing to cover that gap is the most preferable. Money you invest remains yours. Unlike a payroll tax increase, investing gives you have a choice regarding when and how much you spend, so you can cut back if times get tight. And unlike a benefit cut, investing on your own gives you a good chance at keeping your retirement income in line with your expectations.
Where can you invest?
As you look to cover Social Security's shortfall through investing, you likely have three primary options on where to invest your money:
- Through a 401(k) or similar employer-sponsored retirement plan.
- In a tax-sheltered individual retirement account (IRA).
- In a standard brokerage account.
Of the three, your employer-sponsored 401(k) or similar plan is the first one to consider. If your employer offers a match for contributions, it's a no-brainer -- invest at least enough to get the full match, as your boss' money will greatly accelerate your returns. Even if you don't get a match or have already topped out your match, the automatic payroll deduction makes a 401(k) a great way to reduce your temptation to spend the money instead of invest it. Further, a 401(k) shields you from capital-gains taxes and dividend taxes.
The 401(k) contribution limit for people under age 50 is $18,000 in 2015 -- and it rises to $24,000 for those aged 50 or older. If you're already maxing out your 401(k), or if you don't like the plan's choices, or if you don't have a 401(k) available to you, then you can also invest in an IRA. For those under age 50, the 2015 limit is $5,500, and it rises to $6,500 for those aged 50 or older.
IRAs come in two general forms: traditional and Roth. Both options, like a 401(k), allow your investments to grow tax-free. With a Roth IRA, you can take qualifying withdrawals tax-free once you reach age 59-1/2. With a traditional IRA, your contribution may be tax-deductible, butyou pay income taxes on your withdrawals in retirement.
In a standard brokerage account, your dividends are taxed as you receive them, and your gains are taxed when you (or the mutual fund you're invested in) close out a position at a profit. That said, keep in mind that both qualified dividends and long-term capital gains are taxed at a lower rate than ordinary income. A key advantage of a standard brokerage account is that there are no income qualification rules or contribution limits; if you have cash available, you can invest it.
The sooner you start, the easier it will be
While Social Security won't cut off your checks completely, your future benefits are on track to be reduced if nothing else changes. No matter where you choose to invest your money, one of the most important things you can do to cover that gap is to quickly get your plan in place. The sooner you get started, the easier and cheaper it will be for you to build a portfolio capable of covering that gap -- so get started today.
The article Social Security Will Not Cut Off Your Checks originally appeared on Fool.com.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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