What is Social Security, and how does it work?

August 10th, 2012 madmin

This material was prepared for John Evans, LPL Financial Advisor, use.

The Social Security program was established in 1935 and provides old age, disability and survivors insurance, as well as supplemental security income, an income for elderly or disabled people.

So how exactly does it work?

Benefits are mainly financed by a 12.4 percent tax on earnings, split evenly between workers and employers. Annual benefits depend on how much you earn and pay in tax. The more you earn and pay in tax, the higher your benefits will be. Let’s imagine you earn $41,700 in annual earnings. Social Security will replace 40 percent of those earnings if claimed at age 65. This would result in annual benefits (if claimed at age 65) of $16,700. This number would go up or down based on your earnings. Your age when you claim benefits also impacts annual benefits.

Is Social Security enough?

Social Security provides a basic income, not enough to maintain our standard of living. As a result, most people need to supplement Social Security with employer pensions, 401(k)s and individual savings.

Social Security benefits are adjusted to keep up with inflation. And the checks keep coming as long as you live. Other sources of income often dry up towards the end of life, when you are most vulnerable. Social Security thus provides 70 percent of the income to 70 percent of households headed by someone age 80 or over.

When can you claim Social Security benefits?

You can claim benefits at any age between 62 and 70. You collect for more years if you claim at 62. But Social Security adjusts the annual amount to keep lifetime benefits much the same. Annual benefits are thus much lower if claimed at 62 and much higher if claimed at 70. Social Security will replace less of your earnings going forward because:

  • The government is raising the age when you can claim full benefits from 65 to 67.
  • Medicare premiums, which are deducted from Social Security checks before they’re sent out, will take a greater share of benefits.
  • More benefits will be subject to income tax.

By 2030, benefits for the average worker who claims at 67 will fall to 36 percent of earnings, and to 28 percent net of Medicare premiums and income taxes vs. 37 percent today.

John Evans is a LPL Financial Advisor at MidWestOne Bank. He specializes in investments and retirement planning.

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