Americans are relying on Social Security in retirement, but many misunderstand how it works

If you are like most Americans, you are relying on Social Security as a source of income during your retirement-age years.

In fact, a whopping 73% of consumers age 45 to 75 surveyed in the 2023 Protected Retirement Income and Planning study found that are depending on reliable Social Security income to be there for them in retirement.

The survey, conducted by the Alliance for Lifetime Income and Cannex, also found that 40% of Americans consider Social Security to be a critical part of their retirement income. Social Security is even more important for so-called “Peak 65” women (ages 61-65), 54% of whom have less than $100,000 in assets compared to 48% of Peak 65 men. The survey also found that 40% of all the individuals in the Peak 65 group say Social Security is or will be a critical part of their retirement income.

Peak 65 is a term used to describe the demographic phenomenon of more Americans turning 65 in a single year than ever before in history. This milestone will occur in 2024, when an estimated 4 million Americans will reach the traditional retirement age. The Peak 65 generation is made up of baby boomers, who were born between 1946 and 1964. This generation is the largest in American history, and they are also the most diverse.

It's no wonder that baby boomers and others have concerns about Social Security. After all, Social Security is a complex system that has been the subject of many misconceptions over the years, and it’s important to understand basic truths about a program that so many Americans are depending on.

What are common misunderstandings about Social Security?

Many misconceptions surround Social Security, including the belief that it solely offers retirement benefits and that the trust fund is empty due to mismanagement. Some individuals mistakenly think they'll only receive an amount equivalent to what they paid in taxes, while others assume early benefit claims result in greater lifetime sums. There's a misunderstanding that benefits are always tax-free, and that those who haven't worked can't access benefits. While some view Social Security as a comprehensive retirement plan, it's meant to supplement other savings. Concerns about the program's solvency have led to undue fears about its total dissolution, and debates persist over the potential advantages of private investment over Social Security contributions.

Let’s take a closer look at five common questions and misunderstandings about Social Security.

Is Social Security just retirement benefits?

While retirement benefits are a significant part of Social Security, the program also provides disability benefits, survivors' benefits and Supplemental Security Income (SSI). When many people hear Social Security, they immediately think of the monthly checks received by retirees. And while it's true that retirement benefits are a significant and highly visible part of the Social Security system, they represent just one facet of a broader safety net designed to help various groups of people.

Social Security provides disability insurance (SSDI) for individuals who become disabled and can't work, and who meet certain medical criteria. This benefit isn't solely based on the severity of a disability but also takes into consideration the individual's ability to work. For those who qualify, SSDI can provide crucial financial support.

When a person who has worked and paid into the Social Security system dies, their surviving dependents may be eligible for survivors' benefits. This includes widows, widowers and dependent children. The purpose is to provide some level of financial support and continuity in the wake of a family member's death.

Supplemental Security Income is administered by the Social Security Administration, but it's a separate program from the Social Security benefits funded by payroll taxes. SSI provides financial aid to elderly, blind or disabled individuals with little to no income, offering them basic means for food, clothing and shelter.

The breadth and complexity of the Social Security system underscore its role not just as a retirement program, but as a multifaceted safety net designed to assist a broad cross-section of Americans at various stages and situations in their lives. By understanding the full scope of benefits provided by Social Security, one can better appreciate its comprehensive approach to social welfare and its impact on countless lives.

Is the Social Security trust fund empty?

There's a misconception that politicians have “raided” the trust fund, leaving IOUs. In reality, the Social Security trust fund invests in U.S. Treasury securities. While there are concerns about long-term solvency, the fund is not empty.

The Social Security trust fund is not a giant vault of cash; instead, it’s an account containing U.S. Treasury securities. These are government bonds that the federal government is obligated to repay with interest. When the Social Security program collects more in payroll taxes than it pays out in benefits, the surplus is invested in these securities.

Some critics describe the Treasury bonds in the trust fund as mere "IOUs." While it's accurate that these bonds represent promises by the U.S. government to repay borrowed funds, it's important to recognize that U.S. Treasury securities are among the world's safest investments. They are backed by the "full faith and credit" of the U.S. government, making the notion of them being just "worthless IOUs" misleading.

It's true that projections indicate that, due to demographic changes like the arrival of Peak 65, the trust fund will eventually deplete its reserves, currently estimated to occur in the 2030s. However, "depletion" doesn't mean the system will be bankrupt or that benefits will cease. Even if the trust fund reserves were to run out, ongoing payroll taxes collected from workers would still fund approximately three-quarters of promised benefits. While the Social Security trust fund faces genuine long-term challenges, the idea that it's simply "empty" or filled with worthless promises is a profound oversimplification. Recognizing the nuances of the system is essential for informed discussions about its future.

Do get back what you pay into Social Security?

The benefits one receives from Social Security aren't directly tied to the exact amount one paid in Social Security taxes. The system uses a formula based on your 35 highest earning years, and it's designed to be progressive, meaning those with lower lifetime earnings will get a higher replacement rate than higher earners.

At its core, Social Security functions not only as a retirement program but also as a social insurance system. Lower-income workers get a higher "return" on their contributions than higher-income workers. This is intentional, as the program aims to provide a safety net for those most in need. In some cases, beneficiaries may receive more than they've contributed, while others might get back less.

The amount you receive from Social Security will also depend on how long you live. If you live well into your 90s or even 100s, you might end up receiving far more from Social Security than you ever contributed. Conversely, if you live a shorter lifespan, you might collect less than you put in.

It's also essential to consider that Social Security isn't just about individual contributions and benefits. A worker's contributions can lead to benefits for their spouses, children or even parents in certain circumstances. For instance, when a worker dies, their surviving spouse or children might receive benefits based on the deceased's work record, even if the sum of these benefits exceeds the worker's contributions.

Plus, benefits are adjusted for inflation, ensuring that the purchasing power of Social Security income doesn't diminish over time. So, while someone might have contributed a certain dollar amount over their working life, they will likely receive benefits in future dollars that have been adjusted upward for inflation.

If I take Social Security benefits early, will I get more money over time?

The belief that claiming Social Security benefits as early as possible will yield more money over the long run is a common misconception. Many people believe that starting benefits at the earliest age (currently 62) will lead to more money in the long run. However, taking benefits early results in a permanent reduction in monthly amounts. This reduction can be substantial, sometimes amounting to a permanent decrease of up to 30%. Depending on life expectancy, this could mean less money over a lifetime compared to waiting until full retirement age or later.

While claiming early means getting checks sooner, it also means receiving smaller checks for life. Eventually, the total amount received by someone who waited until full retirement age (or later) to claim may surpass what an early claimer receives, even though the latter started getting benefits earlier. The "break-even age" is typically in the late 70s to early 80s, depending on specific claiming ages and benefit amounts.

Waiting even beyond full retirement age can increase benefits further, thanks to delayed retirement credits. In the U.S., these credits can boost one's benefit by a certain percentage (up to 8% per year) until age 70. This can significantly increase the lifetime benefits for those who live into their late 80s or 90s.

Another consideration is that the decision to claim early can have ripple effects on a spouse. For couples, if one partner had notably higher lifetime earnings, it might be beneficial for that partner to delay benefits to maximize the survivor benefit for the lower-earning spouse in the event of the higher earner's death.

Individual circumstances, health status, financial needs and life expectancy all play roles in determining the optimal claiming strategy. Understanding the long-term trade-offs is crucial in making informed decisions about when to initiate benefits.

Are Social Security benefits non-taxable?

The belief that Social Security benefits are entirely non-taxable is a misconception. While Social Security benefits do receive favorable tax treatment, in specific circumstances, a portion of these benefits may be subject to federal income tax. Depending on your combined income (which includes wages, taxable pensions, interest, dividends and some other factors), up to 85% of your Social Security benefits might be taxable.

Whether Social Security benefits are taxable depends on what is termed "provisional income." This includes your adjusted gross income, non-taxable interest (like interest from municipal bonds) and half of your Social Security benefits. Based on this combined amount, one can determine how much of the Social Security benefits might be taxable.

For individual filers with a provisional income between $25,000 and $34,000, up to 50% of Social Security benefits may be taxable. If the provisional income exceeds $34,000, up to 85% of the benefits may be taxable. For married couples filing jointly, if provisional income is between $32,000 and $44,000, up to 50% of Social Security benefits may be taxable. If the provisional income exceeds $44,000, up to 85% of the benefits may be taxable.

As of 2023, 11 states – Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, Rhode Island, Utah and Vermont – taxed Social Security benefits.

The tax rates on Social Security benefits vary by state. In Colorado, for example, Social Security benefits are fully taxable for residents under age 65. For residents over age 65, Social Security benefits are only taxable if the recipient's total income is above a certain threshold.

In Connecticut, for example, Social Security benefits are taxable for all residents, regardless of age. The tax rate is 5% for benefits up to $8,500 and 7.5% for benefits above $8,500.

The tax rates in other states are similar. In general, the tax rate is lower for benefits that are received by residents over age 65.

It’s important to note that even if you live in a state that taxes Social Security benefits, you may not have to pay taxes on all of your benefits. The amount of your benefits that is taxable depends on your total income, including your Social Security benefits, your income from other sources, and your filing status.

While Social Security benefits do enjoy a level of tax protection, they are not universally tax-free. Understanding the nuances of Social Security taxation can help retirees better plan and potentially reduce their tax burden.

Summary

Misunderstandings about Social Security are plentiful. A common misconception is its exclusive role in providing retirement benefits, and many mistakenly believe the trust fund is depleted. The assumption that beneficiaries only retrieve what they've contributed is prevalent, as is the idea that claiming benefits earlier always yields more in the long run. Many are under the impression that Social Security benefits are perpetually non-taxable and think that those without work history are ineligible. Instead of viewing it as a supplementary safety net to other retirement savings, some see it as a primary retirement solution. The program's longevity often gets questioned, feeding unwarranted fears of its complete disappearance.