Social Security Taxes a Good ‘Investment’ For Americans

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Staring at my wife’s annual tax documents this weekend, I couldn’t help getting fired up over what she paid into Social Security last year.

When I pointed out the money sunk into the entitlement program — a 6.2% haircut on her modest salary — she simply shrugged. And when I asked whether she thought she would ever see that money again, she just shrugged again.

I love my wife because she is so temperate. But she’s also not much of a planner. What if I get hit by a bus tomorrow? What if we suffer another market meltdown and her 401(k) plan goes up in smoke? Would this so-called social insurance actually provide for her if she had no other option, or would she be better off if the government just stopped taking its 6.2% and left her the heck alone?

There had to be a point where an individual could better provide for himself or herself than Social Security would. So using my wife’s income and payroll taxes as a case study, I set out to find it.

I did. But where it was surprised me, not only by proving how well Social Security works in its current form, but how it will even work well in a diminished form should our politicians fail to act.

Uncle Sam can keep our Social Security taxes

For starters, let me share some figures with you from my wife’s W-2:

A 30-year-old copy editor at a small newspaper in Annapolis, Md., my wife made $37,638 last year. At a 6.2% rate, she paid $2,333.56 in Social Security taxes in 2010. In her working life, she has paid a total of $12,955 into the program, according to her annual statement from the Social Security Administration.

As estimated by the SSA, if she continued working and paying taxes at this rate, her benefits would be $1,440 a month at her “normal” retirement age of 67. That’s $17,280 a year. For the record, a worker can opt in earlier or later than 67 and receive either smaller or larger payouts, but for simplicity sake I’m sticking to this “normal” age and disbursement figure.

So at 6.2% a paycheck, at retirement (that’s 37 years from now), my wife would have paid $86,341.72 into Social Security. Throw in the cash she’s paid in so far and you get a grand total of $99,296.72.

Those are real dollars, according to the SSA — and nearly a hundred grand is hardly chump change. But if you divide this total by the yearly benefits, it only equals 5.7 years of Social Security payouts at the “normal” rate — or until my wife is a few months shy of 73. That’s well short of the 78.4-year life expectancy in the U.S.

So Social Security is a better way to provide for her — or, put in a more morbid way, if she doesn’t die before 74, she comes out ahead.

But who would just stick a hundred grand in the sock drawer? Anyone in their right mind would put that money to work.

Keep reading for more on Social Security taxes and investing

Yet a conservative strategy that generates just 2% annual returns doesn’t really stretch the nest egg enough. According to a handy Bloomberg retirement calculator that helps with compound interest, even if Uncle Sam forked over previous payments and allowed my wife to start investing her 6.2% per paycheck tomorrow, her total nest egg at age 67 would be just $153,130.68. That’s 8.9 years — or until almost age 76. Again, not even on par with the average life expectancy.

A 5% annual return is better, with $316,183.24 in total at retirement. That’s worth 18 years and a few months, or until age 85. That’s comfortably above the average life expectancy but still problematic. First of all, there’s not much room for error if you want to have to earn 5% a year. For instance, the S&P 500 has returned exactly zero in the last 13 years, and that’s without adjusting for inflation. That’s a heck of a hole to dig out of, even for someone with decent investing skills.

And, practically speaking, does the average American have the discipline to save that 6.2% every paycheck? And what happens if my wife lives to by 86 — or 96, or 106?

In a nutshell, Social Security is the best choice for people in their 30s — that is, unless they plan on dying early or can be sure they are investing whizzes.

Even at partial payouts, Social Security works

Of course, a heck of a lot can and will happen to the Social Security program by the time my wife is ready to retire. Here are just a few possibilities:

According to literature from the Social Security Administration, “in 2037 the Trust Funds will be depleted … [but] if modifications to the program are not made, there would still be enough funds in 2037 from taxes paid by workers to pay $760 for every $1,000 in benefits scheduled.”

I won’t bore you with all of the numbers, except to say that, even at a 76% payout, the government still sets a very high bar for an individual to beat. The full nest egg would last her until age 74 at this lower payout rate, a 2% return would get her to age 78 and a 5% return would get her to 91. Age 91 is very comfortable, but of course the same questions about the high standard or a 5% annual return apply.

Of course, some will suggest that the benefits could be far less than 76%. They could be zero. There is also the prospect of higher taxes for workers paying into the program, meaning we lose more on the front end. But just as those are possibilities, so are the prospects of reforms. A lot can happen in 37 years. For instance, consider that 37 years ago Bill Gates hadn’t even started at Harvard — let alone dropped out to start a little company called Microsoft (NASDAQ: MSFT). So, while anything is possible on the downside, we have to admit that anything is possible on the upside, too.

Social Security not so insolvent after all

I was prepared to write this column proposing that my wife write off the $12K she had paid into Social Security as severance, in exchange for Uncle Sam’s giving her a 6.2% payroll-tax cut. But, as it turns out, she’d be worse off that way.

The opt-out plan only makes sense if my wife dies young (perish the thought), she can generate returns in excess of 5% annually on the cash across 37 years (difficult even for a smart woman like her), or Social Security is significantly altered to pay out drastically reduced benefits or take in significantly higher taxes in the years to come.

Some would also point out my wife’s portion is not the full amount paid into Social Security since her employer pays the same amount into the trust. We can argue about tax cuts for businesses, but for the purpose of this example I have simply focused on the tax burden on my wife. Besides, to think that workers would see a bump in pay if the government eliminated the employer contribution to Social Security is a bit naive. That’s like assuming if the government cut the corporate tax rates that we would all get pay raises in kind.

But perhaps the most important point here is that this is just an intellectual exercise using my wife’s finances. She doesn’t expect Social Security to be her only retirement plan and has a 401(k) and a savings account she builds each month as her prospective play money in the years to come. But the sad reality is that many Americans don’t have these extra finances to fall back on. In some cases, my wife’s $37,638 salary would be a family’s entire household income — and given the paltry U.S. savings rate of around 5%, Social Security is literally the only way to pay the bills once these people are physically unable to work due to old age.

We would do well to remember that. Even though the data show Social Security is a decent “investment,” by it’s very name we should know that the program was never meant to be a substitute for your 401(k) — it’s a safety net, not a retirement plan. That’s why the SSA also pays disability payments to younger Americans who are unable to work on top of its flagship payments to seniors that get all the attention.

In short, as a social safety net for older Americans, the outlook for Social Security is strong. And for Americans like my wife who — knock on wood — will have other sources of cash, the SSA not only makes them whole but has a good chance of delivering more than it took in taxes. To me, that means this program is a success.

But then again, I’m only 30. What do I know about retirement?

Jeff Reeves is editor of InvestorPlace.com. Follow him on Twitter via @JeffReevesIP.


Article printed from InvestorPlace Media, https://investorplace.com/2011/02/social-security-taxes-payroll-tax-investing-retirment/.

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