Years ago, I had a client, Chris, who asked me whether Social Security was a good retirement investment vehicle, or if he should invest the cash instead. Chris was self-employed and had structured his business as an S-Corporation. He could either pay himself a large salary, and maximize the payments into Social Security, or pay himself a minimal salary and take most of his income as profit on the business, which would avoid Social Security payments. Many business owners prefer to minimize Social Security payments so they can invest more in their business. Chris did not need to reinvest in his business and wanted to save for his retirement. As a business owner, Chris would need to pay not only the 6.2% employee contribution, but also the employer contribution, bringing the total to 12.4% of his income up to the maximum wage base. However, if he avoided the Social Security tax, he would also forgo the benefits of Social Security payments when he retires. Would he be better off investing this in a savings account or paying the Social Security tax?
Social Security Basics
The Social Security Act was signed by FDR on 8/14/1935. Taxes were collected starting in January 1937, and the first payments started three years later in January 1940. The purpose was to address the economic security for the elderly in the United States, which was a major problem during the great depression. Many people today think of it as a retirement savings program, but it was designed as a “pay as you go” system, where taxes collected today go to recipients today. It was intended to be both a vehicle to provide a pension Payment to anyone who contributes, and a method of wealth redistribution, to help poorer elderly people. It does this by providing more, as a percentage of original income, to lower-income recipients. In 2023, if you have earned, on average, less than $1,115 per month* over 35 years of working, you will receive 90% of your income as a benefit. If you have earned more, you will receive 32% of the amount over $1,115 up to $6,721. Any amount you earn over $6,721 will provide you with 15%, up to the maximum wage base. These numbers are calculated based on 35 years of earnings and are adjusted annually for inflation.
Most people know some of the details of Social Security benefits. The following is a list of some of the more important considerations:
- You can take benefits as early as 62 at a reduced rate, your full retirement benefit is between 66 and 67 (depending on your year of birth), and you can delay retirement benefits by waiting until age 70 to earn the most possible from the amount you have paid in.
- Social Security is a joint benefit: if you are married, your spouse is eligible for benefits as well. Spousal benefits are typically ½ of your benefits.
- Unlike many pension benefits, Social Security benefits grow with inflation every year.
- Between 15% and 100% of the benefit is tax free, depending on your other income.
- If you die, your spouse will then receive your benefit amount instead of their ½ benefit. These spousal benefits are also available to divorced spouses, subject to a Family Maximum Benefit.
- Starting in 1965 there are also medical benefits provided through Medicare and Medicaid, which are separate government agencies but are often combined with Social Security in the minds of many Americans.
The calculation I ran a couple decades ago indicated that Social Security would provide a higher benefit when compared to investing the amount of Social Security tax and purchasing an immediate annuity with the pot of money. However, the Social Security wage base has increased significantly since then, and so I have re-calculated the estimated benefits.
I looked at two hypothetical situations: one with someone turning 67 in 2023, having contributed the maximum amount to Social Security for 35 years, and another with someone turning 67 in 2023 having earned the U.S. Median Income** every year for 35 years. I assumed both are married, and their spouses didn’t work, so they will receive spousal benefits.
The Maximum income person will receive the maximum Social Security benefit of $3,627 per month, plus a spousal benefit of half that, $1,813 per month, $5,440 total, or $65,280 annually. This compares with an investment portfolio with contributions equaling the same amount annually as the Social Security contributions. I assumed this pot of money earned an average rate of 6% per year pre-tax, or 4.5% after tax (25% combined Federal and State taxes). The pot of money would grow to be worth roughly $860,000 by the time the couple is 67. This amount would purchase a joint and survivor immediate annuity with payments of roughly $4,825 per month ($57,893 per year), with 50% of the benefit provided to the survivor***. Social Security therefore provides roughly 12.76% more than the annuity payment. In addition, the annuity payment would not grow with inflation, and the Social Security benefit will.
For the Median income person, the benefit after 35 years would be $2,646, and the spousal benefit is $1,323, for a total Social Security benefit of $3,969, or $47,628 annually. The pot of money based on the contribution amounts would be worth $450,435, and the annuity that could be purchased with this amount would be $2,331 per month, or $27,972*** per year. As expected, the benefits provided to the lower income individual are better than the wealthy individual, with roughly 70.27% greater benefit than the annuity.
My calculations indicate that Social Security is still a better option when compared with an investment pot of money. It is also guaranteed and backed by the U.S. Government, and the payments continue with an annual cost-of-living adjustment for life.
There are still drawbacks. The government has the right to change the benefit amount. It may need to, as there is anticipated to be a shortfall in the benefits promised starting in 2034. Also, some people would rather have a pot of money that they can live on instead of purchasing an annuity at 67, which would allow beneficiaries to receive the remaining amount if both spouses die early. If you had a pot of money, you would have this choice; Social Security does not have a buy-out option. Also, if you were not married there would not be any spousal benefits, which would change the calculation.
Of course, most people don’t have the ability to opt out of Social Security. While Social Security is required for most employees in the U.S., it is comforting to know that the benefit from Social Security compares well with investments, even for business owners who, like Chris, have a choice.
*Calculations of Average Index Monthly Earnings (AIME) adjust earlier years up to present values.
** Median Income: https://www.multpl.com/us-median-income/table/by-year
*** Annual Payout Ratio = 6.75%, American General Life Insurance Company
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