Where Does Your Social Security Tax Money Go?

By Markets Fool.com

Most working Americans pay a substantial portion of their paychecks toward the Social Security system. 12.4% of the first $118,000 you earn from salary or contractor income gets sent to Social Security. If you're a contractor, you see the full impact of that tax, but if you're a regular employee, only half comes directly from your paycheck, while the other half is paid by your employer as part of your total compensation.

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That's a lot of money flowing into the system, so it may surprise you to learn that everything you pay into Social Security is used to make Social Security benefit payments. In fact, Social Security currently pays out more to beneficiaries than you pay into it from taxes. Between payroll taxes and taxes on benefits for higher-income recipients, in 2014, Social Security collected $785.6 billion in tax revenue versus the $848.5 billion it paid out in benefits. Social Security was able to make those payments ahead of its tax income because of interest earned on its Trust Funds.

How Social Security's cash flow works

Thanks to earning interest, Social Security's Trust Funds actually increased in value by $25 billion in 2014. Those Trust Funds are currently shoring up Social Security, but according to its trustees, that particular source is expected to run dry by 2034, a mere 18 years from now.

The Trust Funds were initially filled thanks to tax dollars flowing into Social Security from people's payroll taxes. Between 1984 and 2009, Social Security regularly ran tax surpluses, which cumulatively put trillions into the program's Trust Funds. The Trust Funds then bought Treasury bonds, which helped the rest of the government finance what was typically deficit spending. The chart below shows the basics of how that funding process works.

Chart by the author.

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In a nutshell, if you look at the numbers in the arrows:

  1. You and your employer pay taxes to fund Social Security.
  2. Those tax dollars go to pay current beneficiaries.
  3. Any income from tax dollars or interest on investments that is not needed to pay current benefits gets loaned to the U.S. Treasury.
  4. The U.S. Treasury hands Social Security bonds in exchange for those loans.
  5. The U.S. Treasury pays Social Security interest on those bonds.

That basic model is expected to hold until around 2019 or 2020, when tax income plus interest is no longer anticipated to be enough to cover benefits. At that time, the direction of arrows 3 and 4 will essentially reverse, as Social Security begins redeeming its bonds to spend down its Trust Funds to cover benefits. Once those Trust Funds empty around 2034, absent any changes to the law, benefits will need to be cut to around 79% of current levels.

What that means to you

This funding model means that if you're working, the money you're paying into Social Security right now gets spent to cover the costs of those currently receiving benefits. It also means that the excess tax money paid into Social Security over the past few decades is expected to be paid back to the system -- with interest -- to cover the program's tax shortfalls over the next 18 or so years.

Unfortunately, the high-certainty nature of the Treasury Bonds that Social Security invests in also means that it's fairly straightforward to project the future of the program. As a result, the pending benefits shortfall that the Social Security trustees project is very real. With that day of reckoning a mere 18 years away, it will affect even some who are currently receiving benefits, not just future recipients.

When you boil it down to its core, there are really only three major tools available for Social Security to try to cover that shortfall:

  1. It can try to increase revenues (taxes).
  2. It can try to reduce expenses (benefits paid to recipients).
  3. It can try to increase the rate of return it earns on its invested Trust Funds.

All three of those tools will likely impact you in some way. If taxes go up, it'll hit you in your paycheck in the form of a lower current salary and the risk of lower future raises due to your employer having to cover the employer part of the tax. If benefits go down, it will hit you as a retiree in the form of a lower Social Security check. If Social Security changes its investing model, it can potentially increase the Trust Funds' lifespans, but at the cost of lower certainty of the money along the way.

What you can do about it

The good news is that while the issues facing Social Security are very real, the biggest impacts from those issues are still several years away. That gives you time to prepare. No matter what combination of those three tools Congress uses to try to shore up Social Security, the best tool at your disposal is to invest a bit more to cover that shortfall.

  • If taxes go up: It's easier to cut back on your investing to handle the increased tax burden than it is to be forced to cut back on your lifestyle to cover the gap in your paycheck.
  • If benefits get cut: The nest egg you build up by saving will supplement the lost income you may have otherwise expected from Social Security.
  • If Social Security changes its investing model: The nest egg you build up will provide you some peace of mind against the greater uncertainty in Social Security's payments. In addition, if Social Security still finds itself on a path to insolvency, you can tap that nest egg to help cover your costs.

The sooner you get started, the better your chances will be of covering either the direct gap from Social Security's Trust Funds emptying or the costs of whatever fixes are put in place to shore them up. So get started now, and within the next two decades, you'll be very glad you did.

The article Where Does Your Social Security Tax Money Go? 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.