How Is Social Security Funded?

By Markets Fool.com

Social Security pays benefits to 60 million Americans, and the federal government has to come up with nearly $75 billion each and every month in order to make those payments to Social Security recipients. With so much talk about how Social Security is in financial jeopardy, it's important to understand where Social Security gets its funding and what is endangering the program's ability to make good on its promise to Americans. Below, we'll take a look at how Social Security is funded and whether you need to prepare for trouble with your Social Security benefits in the future.

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Where most of Social Security's funding comes from

By far, the largest source of funding for Social Security comes from the payroll taxes that most American workers pay. Social Security collects a 6.2% payroll tax that goes toward covering the cost of benefits for current recipients on wages up to a certain annual limit, which for 2016 is $118,500. Employers pay a matching 6.2% tax out of their own pocket, and self-employed people end up paying the combined 12.4% all on their own.

In calendar 2014, which is the most recent year for which data are available, Social Security funding from payroll tax contributions amounted to $646.2 billion. That was about 84% of the total income that Social Security received during the year, and that figure is consistent with the role that payroll tax contributions have historically played in funding Social Security.

Other sources of Social Security funding

In addition to payroll taxes, Social Security gets money from two other main sources. First, Social Security has a trust fund that is invested in U.S. government securities, and those securities pay interest back to the trust fund. During 2014, those interest payments amounted to $94.8 billion, which represented about 12% of Social Security's total funding.

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The other main source for money to pay Social Security benefits is a portion of the federal income tax revenue that the government collects. The Social Security Trust Fund receives money from the U.S. Treasury that results from some Social Security recipients having to include a portion of their benefits as taxable income on their tax returns. This is a relatively small source of revenue, bringing in $28 billion or less than 4% of Social Security's overall income during 2014.

Why Social Security funding is in doubt

Right now, the combination of these sources of revenue is more than enough to cover expenditures of the program. During 2014, Social Security Trust Fund balances for old-age and survivor insurance coverage rose by $55 billion to $2.73 trillion.

In the long run, however, demographic shifts are expected to make financial conditions worse for the Social Security Trust Fund. At some point in the near future, the sources of income won't be enough to cover benefits, which will require the program to start using Trust Fund principal in order to sustain monthly payments. That in turn will reduce the Trust Fund balance, cutting the amount of interest it generates and thereby speeding up the depletion of the remainder. By 2035, the Trustees of the Social Security Trust Fund expect the entire balance to be gone.

What happens if Social Security funding disappears?

One thing to keep in mind is that even once the Trust Fund is used up, it doesn't mean that Social Security benefits will stop entirely. Instead, what will happen at that point is that Social Security will have to take its available funding and spread it out across its pool of recipients. Currently, policymakers anticipate that Social Security will be able to pay roughly three-quarters of what it would technically owe retirees and other Social Security recipients after 2035.

Nevertheless, many believe that taking action is important before the Trust Fund runs out of money. Some believe that increasing the $118,500 maximum on payroll taxation is the fairer way to handle things, while others look at measures to reduce the rate of increase of monthly benefits in order to stretch existing revenue further. Other ideas include making more benefits subject to income tax or reducing Social Security payments themselves for retirees whose incomes are above certain levels.

Social Security funding has been a hot-button topic lately, and the prospect of what could be potentially catastrophic cuts for retirees has many policymakers believing that taking action sooner rather than later is the best way to go forward. Whether a solution involves boosting revenue, cutting benefits, or a combination of both, making the best use of the funding sources for Social Security will be of paramount importance to those expecting benefits.

The article How Is Social Security Funded? originally appeared on Fool.com.

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